Cities and the Financial Crisis

Aalbers, M.B. (2015) Cities and the financial crisis. In: Wright, J.D. (ed.) The Encyclopedia of Social and Behavioral Sciences, pp. 579-584. Oxford: Elsevier Abstract There is a long history in social science that connects urbanization to capitalism. This entry discusses how the work of Manuel Castells and in particular David Harvey informs our understanding of the urbanization of financial crises in the United States and elsewhere. The concepts of capital switching and financialization are central to the argument presented here. The entry also includes a discussion of the management of the crisis, focusing on both the failed institutional response to the financial crisis and the global/local grassroots response to the financial crisis. Keywords: Capital switching Castells, Manuel Financial crisis Financialization Globalization Harvey, David Housing bubble Mortgage market Occupy Wall Street Overaccumulation Residential Mortgage Backed Securities (RMBS) Social movements Subprime lending United States of America Urbanization Cross References: 71074 History of financial crises 72014 Economic geography 72017 Finance, geography of 72023 Globalization; geographical aspects 72032 Marxist geography 72073 Urban geography 72106 Geography of race and racism 74004 Cities; capital, global and world 74020 Neoliberal urbanism 74059 Urban politics in North America 75016 Financial regulation 74016 Housing and cities 72052 Social movements, geographies of 1 Introduction There is a long history in social science that connects urbanization to capitalism. Perhaps two of the most prominent contributions to this nexus are to be found in the earlier work of sociologist Manuel Castells (1977; 1983) and both the early and contemporary work of human geographer David Harvey (1982; 1985; 2010), but it can also be found in older works such as Friedrich Engels’ The Condition of the Working Class in England (1844). For these and other authors, urbanization is a necessary condition for capitalist expansion. Another necessary condition of capitalism, according to the same authors, is that capitalism creates its own crises. To Harvey, one fundamental contradiction in capitalism is that individual capitalists act in a way which, when aggregated, runs counter to their own class interests. This results in overaccumulation and, in time, to a variety of crises. The early signs of crisis often include: an overproduction of commodities, falling rates of profit, surplus capital (e.g. money capital lacking opportunities for profitable employment), and surplus labor or a rising rate of exploitation of labor. Harvey then distinguishes different kinds of crises: a partial crisis which affects a particular sector, place or set of mediating institutions; a switching crisis which involves a major restructuring of capital flows either between sectors of the economy or between places; and a global crisis which affects most sectors of the economy and most places within the capitalist system. The financial crisis that started in 2007-2008 and continues to drag on and mutate in various ways and places can be characterized as a global crisis since it affects most sectors of the economy and most places around the world (Aalbers, 2009). The fact that one can mention sectors or places that are not affected much by the crisis, should not be seen of proof that this is not a global crisis. It is merely proof that some sectors and places have not yet been fully integrated in the global capitalist system or that they are seen as safe havens to switch investment to. This is ‘only’ the third global crisis of capitalism, following the one of the 1930s (with the Second World War as its aftermath) and the one that became most visible after 1973 but that had been building throughout the 1960s. The current global crisis had been building throughout the 1990s and early 2000s. Its earlier manifestations could be seen in more localized events such as the first subprime crisis in the late 1990s in the U.S., the late 1990s Asian and Russian financial crises, the Argentine crisis at the dawn of the new millennium, and the explosion of the dot-com bubble in the early 2000s. These were all partial crises or switching crises because they hit only certain places or certain sectors of the economy and resulted in money capital being switched to different sectors and different places. Two sectors in particular became the main destinations for money capital to flow out of sectors and places in crisis: real estate and finance itself. David Harvey: Capital Switching In Harveyian terms, real estate is seen as an asset in which money can be invested and disinvested by directing capital to the highest and best uses, and by withdrawing and subsequently redirecting capital from low pay-offs to potentially higher ones. Capital switching entails the flow of capital from the primary circuit (production, manufacturing, industrial sector) to the secondary circuit which includes real estate and infrastructure. (Harvey also identifies a tertiary circuit, the circuit of social infrastructure, identified as investment in technology, science, conditions of employees, health and education.) Switching from the primary to the secondary circuit takes place when there is a surplus of capital in the primary circuit and signs of over-accumulation emerge. Capital switching is a strategy to prevent a crisis, but because of the inherent contradictions of capitalism, investment in the secondary circuit will only delay, not take away, the crisis. In empirical terms, the decline in production growth in many OECD countries, the overaccumulation in oil-rich countries, the savings glut in countries like China, and the implosion of the dot-com bubble all resulted in capital switching into the real estate sector. 2 Building on David Harvey’s theory, I have argued elsewhere (Aalbers, 2008) that the early 2000s may have seen the rise of capital switching to what I call the quaternary circuit of capital, where the financial sector is not at work to finance production (first circuit), real estate (second circuit) or the building up of welfare states (tertiary circuit), but simply the growth of money capital through finance. Financialization can be characterized as capital switching from the primary, secondary or tertiary circuit to the quaternary circuit of capital. Financialization not only implies the financialization of existing economies – i.e. the restructuring of existing markets into producer and consumer markets that are heavily tied to financial markets – but also the rise of financial markets for their own good; that is, the rise of financial markets not for the facilitation of other markets but for the trade in money, credit, securities, etc. Or, in the words of Cox (1992: 29), finance is increasingly becoming “decoupled from production to become an independent power, an autocrat over the real economy”. The essence of a quaternary circuit is not that power shifts from the non-financial to the financial sector, but that financial and non-financial firms alike become increasingly involved in financial markets (Aalbers, 2008). And this is not a direct result of a lack of equity, but a direct result of financialization, which rewrites the rules of capital accumulation. Like capital switching to the secondary circuit, capital switching to the quaternary circuit is liable to lead to overaccumulation and eventually to crisis. But capital switching to the quaternary circuit is in at least one way fundamentally different from capital switching to the secondary circuit: while the secondary circuit generally competes for financing in the capital market, the quaternary circuit represents the capital market as an investment channel in its own right. In that sense financialization can be characterized as the capitalist economy taken to extremes: it is not a producer or consumer market, but a market designed only to make money. Although it can be argued that there exists a necessary link between production/consumption and financial speculation, this is not necessarily so: many of the recent crises have their roots in unstable income sources and overaccumulation, as both the Enron debacle and the recent/current financial crisis demonstrate. In a finance-led regime of accumulation, risks that were once limited to a specific actor in the production/consumption chain become risks for all of the actors involved in a specific industry. In that sense, the quaternary circuit, which is in the first place a heuristic tool, is strongly attached to the other circuits of capital. Financialization as capital switching does not deny the necessary link between the different circuits – quite the contrary, it stresses the increased interdependence between the circuits of capital. In addition, it highlights how one of these circuits, the quaternary, comes to dominate the other circuits, to the disadvantage of those circuits (Aalbers, 2008). To see what all this means for cities, we rely again on the work of Manuel Castells who identified four basic elements of a capitalist urban structure: production, consumption, exchange and management (see also Rossi, 2010). Rather than discussing these fours elements one by one, we here discuss the impact of the financial crisis on cities, firstly through a discussion of the link between housing markets and the financial crisis in the U.S. (including production, consumption and exchange), secondly through a discussion of the impact of the crisis more generally speaking, and thirdly through a discussion of the management of the crisis, focusing on both the failed institutional response to the financial crisis and the global/local grassroots response to the financial crisis. Subprime Lending in the United States Real estate is, by definition, local as it is spatially fixed. Mortgage lending, however, has developed from a local to a national market and is increasingly a global market today. An understanding of the financial crisis is ultimately a spatialized understanding of the linkages between local and global. Housing bubbles, faltering economies and regulation together have shaped the geography of the financial crisis on the state and city level in the U.S.. Subprime and predatory lending have affected low-income and minority communities more than others 3 and we therefore not only see a concentration of foreclosures in certain cities, but also in certain neighborhoods (Aalbers, 2009). The default and foreclosure crisis that was at the origins of the financial crisis has hit American households across the country, but people in some states and cities are more likely to be in foreclosure. The rise in default rates started some years ago in the Rustbelt where housing prices went down and unemployment up. The combination of lack of employment and falling housing prices is perilous as people who lose their job in a high unemployment area not only have a smaller chance of finding a new job within a few months, but they also run a bigger chance of not being able to pay off their mortgage loan and might then be faced with negative equity. This implies that lenders will not only see higher foreclosures as a direct result of default, but also because homeowners with financial problems in declining housing markets are less likely to sell their house which would have enabled them to pay off their loan. The rise of subprime lending started in the early 1990s with refinance loans, often in the poorer parts of Rustbelt cities. Increasing default rates led to a first subprime mortgage crisis in 19971998, ten years before the second subprime crisis (Ashton, 2009; Immergluck, 2009). Subprime mortgage lending has been growing fast, from about $35 billion (5% of total mortgage originations) in 1994 to $600 billion (20%) in 2006, 75% of which was securitized. The growth of subprime lending halted for a few years in the late 1990s as a response to the first subprime crisis, but picked up again after 2000 when subprime loans were no longer exclusively targeted at borrowers with low credit scores; “exotic” mortgages were designed to be sold to middle class borrowers, in particular in rapidly growing parts of the country. As a result, the fastest increases in defaults and foreclosures since 2007 were not in the Rustbelt but in the Sunbelt where housing prices had been going up most and exotic mortgages with adjustable interest rates and teaser rates were more common. In some states like Nevada subprime loans accounted for more than 30% of the loans originated in 2006. Subprime lending is often defined as lending to a borrower with poor credit, but this would be a misrepresentation of the essence of subprime lending, which is lending at higher fees and interest rates whether or not the borrower actually has bad credit (Aalbers, 2012). Some estimates suggest that more than half of the subprime loans went to prime borrowers. Up to 2006, the top 10 of foreclosure cities almost exclusively consisted of Rustbelt cities. In 2007, when the crisis started, the list was a mix of Rustbelt and Sunbelt cities, but since 2008, the top 10 of foreclosure cities is entirely made up of Sunbelt cities, although Rustbelt city Detroit occasionally makes it back to the top 10. There are several of such foreclosure lists and they look slightly different, but generally speaking cities in California now make up more than half of them, with cities in the South and Florida completing the list. The differences across the U.S. are huge: the foreclosure rate in Richmond, VA is almost 100 times as low as in Stockton, CA, the foreclosure capital (Aalbers, 2009). Housing prices can go down because of a structurally faltering economy, like in the Rustbelt, but also because they have been going up extremely fast, like in many cities in the Sunbelt. Housing prices in the Sunbelt were simply more inflated than elsewhere in the U.S.: the housing bubble was bigger and more likely to bust. In addition, some local and regional economies in the Sunbelt also show signs of a declining economy, perhaps not structurally, as in the Rustbelt, but conjuncturally. Furthermore, high economic growth also meant a lot of new construction and more homeowners who recently bought a house, thereby increasing the pool of possible victims of falling housing prices. Finally, several states in the U.S. have geared up their own regulations to impede some of the many excesses of subprime lending. As Wyly et al. (2009) have shown, states like North Carolina, New Mexico, Massachusetts and West Virginia regulate a wide range of practices, related to foreclosure rules, loan flipping, prepayment penalties and other things. New Mexico, for example, introduced the Home Loan Protection Act (2003). 4 Most subprime loans are granted to people to refinance their mortgages or as second mortgages (Squires, 2009). This means that most of these loans do not enable homeownership among low-income and minority groups, as is often argued. Subprime, and in particular predatory, loans frequently result in mortgage foreclosures at the individual level and housing abandonment at the neighborhood level. It is not just defaulting borrowers that are hit; in addition, there are severe spillover effects on housing prices, crime and neighborhood decline. Although some cities in the Sunbelt are now hit harder than those in the Rustbelt, on a neighborhood level the Rustbelt still tops the foreclosure lists. On the list of most foreclosed zip codes, four are now in Detroit, while the Slavic Village in Cleveland has the most foreclosure filings. From the 1950s onwards, redlining and suburbanization hit this neighborhood hard. Due to a combined economic and foreclosure crisis, demand for housing has fallen so dramatically, that one can now buy many homes in the Slavic Village that are priced under $30,000; on E-Bay you could even buy one for less than $5,000. The Slavic Village, now referred to as foreclosure’s ground zero, has also seen a rapid increase in crime. Besides borrowers and neighborhoods, cities are also hit hard because tax income goes down due to foreclosed properties and lower real estate prices, while expenses are increasing as a result of foreclosures and property crime (Dymski, 2010; Immergluck, 2009). Local governments around the country have cut expenses on education, infrastructure and social services. The public school system in California alone faces a loss of $4 billion in funding. Many cities in these states, but also in countless others, are facing lower incoming taxes (in particular real estate taxes) and cuts in funding of schools, social services, garbage collection, infrastructure etc. One complication in the U.S., and possibly elsewhere, is that local governments as well as many states are not allowed to run a deficit. While the national government tries to stimulate the economy by spending more, municipalities and many states that are faced with decreasing revenues also have to cut back on expenses. This is by no means a marginal development. State revenues in New York, a state that in no way presents a worst-case scenario, have come down 36% in one year. Crises around the World The current financial crisis originates in the housing and mortgage markets, but it affects financial markets and economic sectors around the world (Aalbers, 2009; French et al., 2009). A few decades ago most mortgage lenders were local or regional institutions. Today, most mortgage lenders are national lenders who tap into the global credit market. This is not so much the case because lenders are global financial institutions – most lenders are national in scope – but because they compete for the same credit in a global market. The idea was that in the wider credit market it would be easy for mortgage lenders to get money, as mortgages were considered low-risk. Mortgages would be an ideal investment for low-risk investors. Cheaper credit, in return, would lower interest rates on mortgage loans. Fannie Mae and Freddie Mac already introduced securitization in the 1960s, two government-sponsored enterprises that were meant to spur homeownership rates for low- and middle-income households. Securitization enables mortgage lenders to sell their mortgage portfolio on the secondary mortgage markets to investors (Aalbers, 2012). The credit crisis started in 2007 when foreclosure and default rates went up and housing prices went down. This implied that investing in mortgages was not as low-risk as people thought. The value of Residential Mortgage Backed Securities (RMBS) fell even more dramatically. This is not only the case because many people had mortgage loans that were granted without down-payments, but also because RMBS were sold with the idea of high returns. These high returns were partly based on high interest rates and not just on the value of the house, and partly on speculation which increased the value of RMBS beyond what they were actually worth. In sum, not only were risks underestimated, returns were also overestimated (even if there wouldn’t have been rising defaults). In addition, even though housing prices on average fell by 20%, the impact on the RMBS market was much bigger. This is not just a result of inflationary prices, but also of leveraging. Major players in the RMBS market like investment 5 banks basically invested with borrowed money (ratio’s of 1:20 were not uncommon, 1:14 being the average) and because of this leveraging both profits and losses would be disproportionally big. It now becomes easier to understand why the impact of partly local and partly national problems in housing and mortgage markets is global in scope and also affects other credit markets. The crisis does not just hit investment banks on Wall Street, European banks and pension funds that bought RMBS, but also individual investors and cities and towns around the globe. The example of Narvik in the far north of Norway is widely discussed (e.g. Aalbers, 2009). The city council of Narvik (population: 18,000) and three small, nearby municipalities had invested $78 million of the revenues of a nearby hydroelectric plant in RMBS and other products offered by investment banks – they lost most of it. The city’s investments were meant for the construction of a new school, a nursing home and a child-care facility. Instead, the city has cut the budget and as a result several small rural schools will be closed, budgets for elderly care have been cut, the city is behind payments to civil servants, and the fire department will seize their 24/7-service and will switch to day-time service (in a city with mostly wooden houses). The Norwegian state has declared not to help Narvik and other municipalities, as it does not want to set a precedent by which the national state has to bear the losses of local authorities. Of course, Narvik is not the exception. Cities and towns around the globe have been hit by the financial crisis. We could tell stories of cities in Greece, Spain, Ireland and Iceland that have all been severely hit, but also of cities in countries that seem to weather the financial crisis, whether they are located in Germany, Turkey, Brazil, China or Australia. In some way, the crisis is felt in most economic sectors and in most places around the world. The only-partial inclusion of for instance China in the global capitalist system has meant that production growth was slowed down but not that the country entered a recession. Yet, the rapid increase in the number of vacany luxury apartments in Chinese cities suggests that Chinese capitalism is also feeding local and national real estate bubbles – bubbles that result from a switching crisis and may one day result in a crisis of real estate and perhaps a larger economic crisis in China and likely elsewhere. It is crucial to link the spatial and temporal dimensions of local and global crises alike. Cities, pensions funds, sovereign wealth funds and individuals around the world had invested in RMBS or the financial institutions that went down in this crisis such as the American Lehman Brothers or the Icelandic Landsbanki. Narvik illustrates well how connected the world has become in the 21st century. It also illustrates well that the world is not flat today: the old geography of local housing markets has not been replaced by a global housing market, but by a chain that starts with local (a mortgage loan on a particular property), turns national (through lenders), then global (in the RMBS market) and then local again (by the effects in places like Narvik). Nearly everyone in North-America, Europe and Australia, and many in Asia are in some involved in this crisis, often as passive investors, e.g. through pensions funds or investments by their local governments. We may not all be capitalists now, but most of us are investors, whether we want – or know – it or not. Crisis Management The financial crisis and its aftermath are often seen as a crisis of neoliberalism and although it could be seen this way, what we have witnessed in the last couple of years is not the dismantling of neoliberalism but, by and large, the furthering of neoliberalism (IJURR, 2013). The financial crisis is leading to cutback after cutback. A core element of the state response to the crisis has, in the first place, been the government bailout of private companies on the one hand and austerity measures for everybody else on the other. And although there is now a lot of talk about more regulation, a lot of this will not necessarily be unbeneficial to the neoliberal agenda. Moreover, the end-result of this crisis may very well be the further 6 dismantling of the welfare state. There are already many examples that point in this direction, both at the local and the national level (IJURR, 2010; 2013). The power of neoliberalism is that it furthers its agenda in economic boom periods as well as in economic bust periods. This is also visible in many European countries with relatively strong welfare states where the current crisis provides neoliberals with the opportunity to cut money on state spending and to further the commodification of labor power, for example by adjusting collective labor agreements or by forcing workers to choose between unemployment for some and wage cuts for all. The story is now repeating itself, not just in American cities hit hard by foreclosures such as Stockton, California and Cleveland, Ohio but also in many European countries, from hard-hit ones like Greece, Spain, Iceland or Ireland to less affected ones such as the UK, France, Germany or the Netherlands. Both local and national governments around the globe face public cuts. Ironically, neoliberalism is to blame for the problems but also prescribes the “solution” to the problem: showering giant corporations with public money and cutting all other public spending (IJURR, 2013). As U.S. Secretary of State Timothy Geithner said: “We saved the economy, but we kind of lost the public doing it.” It took surprisingly long before the financial crisis resulted in mass demonstrations. The streets of Dublin remained almost empty after the government had bailed out the banks at the expense of its citizens. Cutbacks in Greece and Spain have resulted in many a demonstration, but it was the Occupy Wall Street (OWS) movement that resulted in something more akin a global (albeit far from complete) grassroots response to the financial crisis, even though OWS itself was inspired by revolts throughout the Mediterranean region (Aalbers, 2013). OWS has not physically occupied Wall Street, it has occupied a pocket park formerly known as Liberty Plaza, but renamed to Zuccotti Park in 2006. At times, Brookfield, the owner of Zuccotti Park, has requested the Mayor and the New York Police Department (NYPD) to evict the demonstrators. The NYPD has not been in favor of eviction as it is easier to contain the occupiers in one easily surveillable place than have the protestors sprawl out around Lower Manhattan. For a few weeks the strategy of ‘Brookberg’ or ‘Bloomfield’ seemed to be to freeze the protesters out, but on the night of November 14-15, 2011 the Mayor had Liberty Plaza cleared without prior announcement. That night about 200 people were arrested. After the plaza was cleaned, the protesters were allowed back in, but they were not allowed to put up tents or sleep on the plaza. At the time of finishing this entry, a small group of protestors continues to occupy the plaza during the day. The problem Brookberg has with OWS is that it is hard to discuss with the protestors what should be done for them to leave Zuccotti Park. The reason for this fundamental uncertainty is only in part a result of the heterogeneous nature of the occupiers. All social movements show a degree of heterogeneity but most still come up with a shared agenda. OWS has nOt because it fights against something that is much harder to identify: the contemporary, internationalized, financialized economy. One of the many things the current global financial and economic crisis demonstrates is that large parts of our economy are really beyond our control and often even beyond our imagination. We used to think of the financial sector as a sector that made other things possible, a sector that enabled people to buy houses, students to go to college and entrepreneurs to start or expand their businesses. Some might have seen financial institutions as evil but most would agree that they were necessary evils. What the financial crisis revealed is that financial institutions engage in a great deal of activities that are not useful to the economy at all. A mortgage loan may enable someone to buy a home, but many predatory subprime loans were designed to disrupt rather than to disable homeownership. A credit default swap (CDS) may basically work like insurance, but most of them are simply bets against something. If a CDS were like fire insurance, most of them would not be taken out by homeowners but by others who plan to benefit from someone else’s house burning down. The financial sector and media call that innovation, but a lot of financial innovation is simply social destruction (Aalbers, 2013). 7 There is a strong political dimension to all this. First, financial institutions heavily lobby states to get what they want, not just in the U.S. but also elsewhere. They did not simply want less regulation, but sometimes more regulation to enable them to innovate/destruct. This is not only something that happened in the decades prior to the financial crisis, but also something that continues and is undermining re-regulatory efforts. Second, states, in particular though not exclusively in the U.S., have failed to protect their citizens. Financial institutions have been able to prey not only on homeowners and pensioners but also on businesses and the people who depend on them for their livelihoods. States are complicit to the crisis because they have facilitated financial innovation/destruction. Years of neoliberal restructuring, albeit in different forms and intensities, have not yet been repaired by a little more consumer protection and a little more financial regulation. The fundamental question of what state/market relations should be, has hardly been addressed. There is no simple answer and the answer is of course heavily politicized (as it should be), but the 99% are right that there is a general agreement about the under-regulation and under-policing of financial institutions (Aalbers, 2013). Conclusion While in the past a mortgage bubble or a housing bubble would affect the economy through homeowners, the current bursting of these bubbles affects the economy not just through homeowners, but also through financial markets. Because lenders are now national in scope this no longer affects only some housing markets, but all housing markets throughout a country Housing markets may still be local or regional; mortgage markets are not. Since primary mortgage markets are national, the bubble in the national mortgage market affects all local and regional housing markets, although it clearly affects housing markets with a greater bubble more than those with a smaller bubble. In addition, secondary mortgage markets are global markets, which means that a crisis of mortgage securitization implies that investors around the globe, and therefore economies around the globe, are affected. The mortgage market crisis affects the U.S. economy on both sides of the mortgage lending chain – through homeowners and through financial markets – while it affects other economies in the world mostly through financial markets, not just because investors around the globe have invested in RMBS, but also because the mortgage market has triggered a whole chain of events that have decreased liquidity and this affects even agents in financial markets that have never been involved in RMBS. The financial crisis is redrawing the world in many ways and at many levels. Financial globalization’s impacts are logically speaking global, but that doesn’t mean the impacts are the same around the globe although there seem to be few financial institutions that remain unaffected by this crisis. The impact on non-financial institutions has been more spread and affect cities around the world in different ways and in different degrees. Housing bubbles, faltering economies and regulation together have shaped the geography of the financial crisis on the state and city level in the U.S. Subprime and predatory lending have affected lowincome and minority communities more than others and we therefore not only see a concentration of foreclosures in certain cities but also in certain neighborhoods, often those places inhabited by low-income and minority groups that have been excluded by earlier rounds of exclusion and exploitation. Yet, the meanings of globalization, not unlike the causes and consequences of this crisis, remain geographically uneven. It is important to understand that cities are an essential element in both, and that the fates of places like Stockton and Narvik are not only related to each other, but also to those of Wall Street and Raffles Place (Singapore). 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