Many on Wall Street are still digesting the momentous events of the last ten days:
- 1-3 trillion dollars worth of financial assets wiped out.
- Wall
Street effectively nationalized, with the Federal Reserve and the
Treasury Department making all the major strategic decisions in the
financial sector and, with the rescue of the American International
Group (AIG), the US government now runs the world’s biggest insurance
company. - The biggest bailout since the Great Depression, with
$700 billion, being desperately put together to save the global
financial system.
The usual explanations no longer suffice. Extraordinary events demand extraordinary explanations. But first…
Is the worst over?
No, if anything
is clear from the contradictory moves of the last week—allowing Lehman
Brothers to collapse while taking over AIG, and engineering Bank of
America’s takeover of Merrill Lynch–there is no strategy to deal with
the crisis, just tactical responses, like the fire department’s
response to a conflagration.
The $700 billion buyout of banks’
bad mortgaged-backed securities is not a strategy but mainly a
desperate effort to shore up confidence in the system, to prevent the
erosion of trust in the banks and other financial institutions and
preventing a massive bank run such as the one that triggered the Great
Depression of 1929.
What caused the collapse of global capitalism’s nerve center? Was it greed?
Good
old fashioned greed played a part. This is what Klaus Schwab, the
organizer of the World Economic Forum, the yearly global elite jamboree
in the Swiss Alps, meant when he told his clientele in Davos earlier
this year: “We have to pay for the sins of the past.”
Was this a case of Wall Street outsmarting itself?
Definitely.
Financial speculators outsmarted themselves by creating more and more
complex financial contracts like derivatives that would securitize and
make money from all forms of risk—including exotic futures instruments
as “credit default swaps” that enable investors to bet on the odds that
the banks’ own corporate borrowers would not be able to pay their
debts! This is the unregulated multitrillion dollar trade that brought
down AIG.
On December 17, 2005, when International Financing
Review (IFR) announced its 2005 Annual Awards — one of the securities
industry's most prestigious awards programs—it had this to say:
"[Lehman Brothers] not only maintained its overall market presence, but
also led the charge into the preferred space by … developing new
products and tailoring transactions to fit borrowers' needs…Lehman
Brothers is the most innovative in the preferred space, just doing
things you won't see elsewhere."
No comment.
Was it lack of regulation?
Yes—everyone
acknowledges by now that Wall Street’s capacity to innovate and turn
out more and more sophisticated financial instruments had run far ahead
of government’s regulatory capability, not because government was not
capable of regulating but because the dominant neoliberal,
laissez-faire attitude prevented government from devising effective
mechanisms with which to regulate.
But isn’t there something more that is happening? Something systemic?
Well,
George Soros, who saw this coming, says what we are going through is
the crisis of the financial system is the crisis of the “gigantic
circulatory system” of a “global capitalist system that is…coming apart
at the seams.”
To elaborate on the arch-speculator’s insight,
what we are seeing is the intensification of one of the central crises
or contradictions of global capitalism which is the crisis of
overproduction, also known as overaccumulation or overcapacity.
This
is the tendency for capitalism to build up tremendous productive
capacity that outruns the population’s capacity to consume owing to
social inequalities that limit popular purchasing power, thus eroding
profitability.
But what does the crisis of overproduction have to do with recent events?
Plenty.
But to understand the connections, we must go back in time to the
so-called Golden Age of Contemporary Capitalism, the period from 1945
to 1975.
This was a period of rapid growth both in the center
economies and in the underdeveloped economies—one that was partly
triggered by the massive reconstruction of Europe and East Asia after
the devastation of the Second World War, and partly by the new
socio-economic arrangements that were institutionalized under the new
Keynesian state. Key among the latter were strong state controls over
market activity, aggressive use of fiscal and monetary policy to
minimize inflation and recession, and a regime of relatively high wages
to stimulate and maintain demand.
So what went wrong?
Well,
this period of high growth came to an end in the mid-seventies, when
the center economies were seized by stagflation, meaning the
coexistence of low growth with high inflation, which was not supposed
to happen under neoclassical economics.
Stagflation, however,
was but a symptom of a deeper cause: the reconstruction of Germany and
Japan and the rapid growth of industrializing economies like Brazil,
Taiwan, and South Korea added tremendous new productive capacity and
increased global competition, while social within countries and between
countries globally limited the growth of purchasing power and demand,
thus eroding profitability. This was aggravated by the massive oil
price rises of the seventies.
How did capitalism try to solve the crisis of overproduction?
Capital
tried three escape routes from the conundrum of overproduction:
neoliberal restructuring, globalization, and financialization.
What was neoliberal restructuring all about?
Neoliberal
restructuring took the form of Reaganism and Thatcherism in the North
and Structural Adjustment in the South. The aim was to invigorate
capital accumulation, and this was to be done by 1) removing state
constraints on the growth, use, and flow of capital and wealth; and 2)
redistribute income from the poor and middle classes to the rich on the
theory that the rich would then be motivated to invest and reignite
economic growth.
The problem with this formula was that in
redistributing income to the rich, you were gutting the incomes of the
poor and middle classes, thus restricting demand, while not necessarily
inducing the rich to invest more in production.
In fact,
neoliberal restructuring, which was generalized in the North and south
during the eighties and nineties, had a poor record in terms of growth:
global growth averaged 1.1 per cent in the nineties and 1.4 in the
eighties, whereas it averaged 3.5 per cent in the 1960’s and 2.4 per
cent in the seventies, when state interventionist policies were
dominant. Neoliberal restructuring could not shake off stagnation.
How was globalization a response to the crisis?
The
second escape route global capital took to counter stagnation was
“extensive accumulation” or globalization, or the rapid integration of
semi-capitalist, non-capitalist, or precapitalist areas into the global
market economy. Rosa Luxemburg, the famous German revolutionary
economist, saw this long ago as necessary to shore up the rate of
profit in the metropolitan economies. How? By gaining access to cheap
labor, by gaining new, albeit limited, markets, by gaining new sources
of cheap agricultural and raw material products, and by bringing into
being new areas for investment in infrastructure. Integration is
accomplished via trade liberalization, removing barriers to the
mobility of global capital, and abolishing barriers to foreign
investment.
China is, of course, the most prominent case ofa
non-capitalist area to be integrated into the global capitalist economy
over the last 25 years.
To counter their declining
profits, a sizable number of the Fortune 500 corporations have moved a
significant part of their operations to China to take advantage of the
so-called “China Price”—the cost advantage deriving from China’s
seemingly inexhaustible cheap labor. By the middle of the first decade
of the 21st century, roughly 40 t0 50 per cent of the profits of US
corporations were derived from their operations and sales abroad,
especially China.
Why didn’t globalization surmount the crisis?
The
problem with this escape route from stagnation is that it exacerbates
the problem of overproduction because it adds to productive capacity.
A tremendous amount of manufacturing capacity has been added in China
over the last 25 years, and this has had a depressing effect on prices
and profits. Not surprisingly, by around 1997, the profits of US
corporations stopped growing. According to one index, the profit rate
of the Fortune 500 went from 7.15 in 1960-69 to 5.30 in 1980-90 to 2.29
in 1990-99 to 1.32 in 2000-2002.
What about financialization?
Given
the limited gains in countering the depressive impact of overproduction
via neoliberal restructuring and globalization, the third escape route
became very critical for maintaining and raising profitability:
financialization.
In the ideal world of neoclassical economics,
the financial system is the mechanism by which the savers or those with
surplus funds are joined with the entrepreneurs who have need of their
funds to invest in production. In the real world of late capitalism,
with investment in industry and agriculture yielding low profits owing
to overcapacity, large amounts of surplus funds are circulating and
being invested and reinvested in the financial sector—that is the
financial sector is turning in on itself.
The result is an
increased bifurcation between a hyperactive financial economy and a
stagnant real economy. As one financial executive notes, “there has
been an increasing disconnect between the real and financial economies
in the last few years. The real economy has grown…but nothing like
that of the financial economy—until it imploded.”
What this
observer does not tell us is that the disconnect between the real and
the financial economy is not accidental—that the financial economy
exploded precisely to make up for the stagnation owing to
overproduction of the real economy.
What were the problems with financialization as an escape route?
The
problem with investing in financial sector operations is that it is
tantamount to squeezing value out of already created value. It may
create profit, yes, but it does not create new value—only industry,
agricultural, trade, and services create new value. Because profit is
not based on value that is created, investment operations become very
volatile and prices of stocks, bonds, and other forms of investment can
depart very radically from their real value—for instance, the stock of
Internet startups that keep on rising, driven mainly by upwardly
spiraling financial valuations, that then crash. Profits then depend on
taking advantage of upward price departures from the value of
commodities, then selling before reality enforces a “correction,” that
is a crash back to real values. The radical rise of prices of an asset
far beyond real values is what is called the formation of a bubble.
Why is financialization so volatile?
Profitability
being dependent on speculative coups, it is not surprising that the
finance sector lurches from one bubble to another, or from one
speculative mania to another.
Because it is driven by
speculative mania, finance driven capitalism has experienced about
scores of financial crises since capital markets were deregulated and
liberalized in the 1980’s.
Prior to the current Wall Street
meltdown, the most explosive of these were the Mexican Financial Crisis
of 1994-95, the Asian Financial Crisis of 1997-1998, the Russian
Financial Crisis of 1996, the Wall Street Stock Market Collapse of
2001, and the Argentine Financial Collapse of 2002.
Bill
Clinton’s Treasury Secretary, Wall Streeter Robert Rubin, predicted
five years ago that “future financial crises are almost surely
inevitable and could be even more severe.”
How do bubbles form, grow, and burst?
Let’s first use the Asian Financial Crisis of 1997-98, as an example.
- First, capital account and financial liberalization at the urging of the IMF and the US Treasury Dept.;
- Then, entry of foreign funds seeking quick and high returns, meaning they went to real estate and the stock market;
- Overinvestment,
leading to fall in stock and real estate prices, leading to panicky
withdrawal of funds—in 1997, $100 billion left the East Asian economies
in a few weeks; - Bailout of foreign speculators by the IMF;
- Collapse of the real economy—recession throughout East Asia in 1998;
- Despite
massive destabilization, efforts to impose both national and global
regulation of financial system were opposed on ideological grounds.
Let’s go to the current bubble. How did it form?
The
current Wall Street collapse has its roots in the Technology Bubble of
the late 1990’s, when the price of the stocks of Internet startups
skyrocketed, then collapsed, resulting in the loss of $7 trillion worth
of assets and the recession of 2001-2002.
The loose money
policies of the Fed under Alan Greenspan had encouraged the Technology
Bubble, and when it collapsed into a recession, Greenspan, to try to
counter a long recession, cut the prime rate to a 45-year-low of 1 per
cent in June 2003 and kept it there for over a year. This had the
effect of encouraging another bubble—the real estate bubble.
As
early as 2002, progressive economists such as Dean Baker of the Center
for Economic Policy Research were warning about the real estate bubble.
However, as late as 2005, then Council of Economic Adviser Chairman and
now Federal Reserve Board Chairman Ben Bernanke attributed the rise in
US housing prices to “strong economic fundamentals” instead of
speculative activity. Is it any wonder that he was caught completely
off guard when the Subprime Crisis broke in the summer of 2007?
And how did it grow?
Let’s
hear it from one key market player himself, George Soros: “Mortgage
institutions encouraged mortgage holders to refinance their mortgages
and withdraw their excess equity. They lowered their lending standards
and introduced new products, such as adjustable mortgages (ARMs),
“interest only” mortgages, and promotional teaser rates.” All this
encouraged speculation in residential housing units. House prices
started to rise in double digit rates. This served to reinforce
speculation, and the rise in house prices made the owners feel rich;
the result was a consumption boom that has sustained the economy in
recent years.”
Looking at the process more closely, the subprime
mortgage crisis was not a case of supply outrunning real demand. The
“demand” was largely fabricated by speculative mania on the part of
developers and financiers that wanted to make great profits from their
access to foreign money that flooded the US in the last decade. Big
ticket mortgages were aggressively sold to millions who could not
normally afford them by offering low “teaser” interest rates that would
later be readjusted to jack up payments from the new homeowners.
But how could subprime mortgages going sour turn into such a big problem?
Because
these assets were then “securitized” with other assets into complex
derivative products called “collateralized debt obligations” (CDO’s) by
the mortgage originators working with different layers of middlemen who
understated risk so as to offload them as quickly as possible to other
banks and institutional investors. These institutions in turn
offloaded these securities onto other banks and foreign financial
institutions.
When the interest rates were raised on the
subprime loans, adjustable mortgage and other housing loans, the game
was up. There are about six million subprime mortgages outstanding, 40
percent of which will likely go into default in the next two years,
Soros estimates.
And five million more defaults from
adjustable rate mortgages and other “flexible loans” will occur over
the next several years. But securities the value of which run into
trillions of dollars have already been injected, like virus, into the
global financial system. Global capitalism’s gigantic circulatory
system was fatally infected.
But how could Wall Street titans collapse like a house of cards?
For
Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, and Bear
Stearns, the losses represented by these toxic securities simply
overwhelmed their reserves and brought them down. And more are likely
to fall once their books—since lots of these holdings are recorded “off
the balance sheet”– are corrected to reflect their actual holdings of
these assets.
And many others will join them as other
speculative operations such as credit cards and different varieties of
risk insurance seize up. The American International Group (AIG) was
felled by its massive exposure in the unregulated area of credit
default swaps, derivatives that make it possible for investors to bet
on the possibility that companies will default on repaying loans. Such
bets on credit defaults now make up a $45 trillion market that is
entirely unregulated. It amounts to more than five times the total of
the US government bond market. The mega-size of the assets that could
go bad should AIG collapse was what made Washington change its mind and
salvage it after it let Lehman Brothers collapse.
What’s going to happen now?
We
can safely say then that there will be more bankruptcies and government
takeovers, with foreign banks and institutions joining their US
counterparts, that Wall Street’s collapse will deepen and prolong the
US recession, and that in Asia and elsewhere, a US recession will
translate into a recession, if not worse. The reason for the last
point is that China’s main foreign market is the US and China in turn
imports raw materials and intermediate goods that it uses for its
exports to the US from Japan, Korea, and Southeast Asia. Globalization
has made “decoupling” impossible. The US, China, and East Asia are
like three prisoners bound together in a chain-gang.
In a nutshell…?
The
Wall Street meltdown is not only due to greed and to the lack of
government regulation of a hyperactive sector. The Wall Street collapse
stems ultimately from the crisis of overproduction that has plagued
global capitalism since the mid-seventies.
Financialization of
investment activity has been one of the escape routes from stagnation,
the other two being neoliberal restructuring and globalization. With
neoliberal restructuring and globalization providing limited relief,
financialization became attractive as a mechanism to shore up
profitability. But financialization has proven to be a dangerous road,
leading to speculative bubbles that lead to the temporary prosperity of
a few but which ultimately end up in corporate collapse and in
recession in the real economy.
The key questions now are: How
deep and long will this recession be? Does the US economy need another
speculative bubble to drag itself out of this recession. And if it
does, where will the next bubble form? Some people say the
military-industrial complex or the “disaster capitalism complex” that
Naomi Klein writes about is the next one, but that’s another story?