My undergraduate students commonly seem to think that the world doesn't change very much. Yet last week, between 14 September and 18 September, the world changed in quite dramatic ways. The era of free market fundamentalism, ushered in globally with the election of Ronald Reagan on 4 November 1980 and the continuing tenure of then-US Federal Reserve Chairman Paul Volcker at the time, has, without doubt, come to an end. It was, as Mohamed El-Erian, chief executive of the bond fund manager Pimco, said in the Financial Times, 'regime change'. Nouriel Roubini of New York University put it this way in The Globe and Mail: 'this financial crisis signals the beginning of the decline of the American empire'. To adapt the words of Gil Scott Heron to fit the times, the revolution was televised on MSNBC; but many people missed it.
The origins of the events last week have been well-rehearsed in previous entries on this weblog. The US financial crisis has multiple origins, but two dates stand out. Eight years ago Alan Greenspan, the former Chairman of the US Federal Reserve, argued that over-the-counter (OTC) derivatives, the contracts between banks, insurance companies and other non-bank financial firms, should not be subject to US government regulation. As a consequence, OTC derivatives have not been subject to oversight by the Commodities Futures Trading Commission. A year later, in 2001, the same Alan Greenspan started cutting US interest rates in the wake of the September 11 attacks. Greenspan's role in these two events, in that they laid the groundwork for the creation of a huge speculative financial bubble amongst global finance capital searching for profits and households searching for livelihood security, has meant that the man who was once the hero of global finance capital is now a man whose reputation stands, at long last, in tatters.
As US interest rates went lower, US mortgage providers started to look for new markets for their products: and the principal market turned out to be cheap mortgages that could be offered under the low-interest rate regime to people that, for various reasons, could never before in their life have thought about owning a home. The result: too many Americans started buying homes (and, through re-mortgaging, other big purchases like cars) with loans that they could not afford. These mortgage providers then 'bundled' these mortgages together, and sold them to investment banks, who started to repackage the mortgages into a set of increasingly arcane products that could be sold to investors such as non-bank financial institutions looking for 'safe' products with a better rate of return than that offered by 'conventional' investment products such as US government bonds.
In doing this, the investment banks started entering into a world in which they had little experience. Moreover, in order to continue doing this business, investment banks and other non-bank financial companies (like American Insurance Group [AIG]), who do not have deposits that they can tap into as an inexpensive source of money, depended upon continually securing short-term loans from other financial institutions, which they would secure by using the assets that they held--the 'bundled' mortgages. Investment banks and non-bank financial institutions were thus borrowing against assets that were ultimately held by less-creditworthy consumers. In essence, the investment banks and the non-bank financial companies that bought their products were counting on home prices continuing to rise, and thus that the holders of the mortgages being able to meet their debt obligations; the financial alchemy behind the crisis sees finance capital shuffling risk like a juggler keeping balls in the air, while all the while not really understanding the complex products--and obligations--that they were peddling. Indeed, as John Gapper writes in the Financial Times, it was as if finance capital had become addicted to complexity.
The house of cards started to collapse last year, when American mortgage holders who had been paying sub-prime interest rates suddenly found out that, as a consequence of the terms and conditions of their mortgage, their interest rates ratcheted up, and they were now paying far, far more in repayments than that for which they had budgeted. They couldn't afford it; and a wave of foreclosures followed. US house prices of course started to tumble; and the investment banks and non-bank financial companies were left holding bundled complex financialmort products predicated upon bundled mortgages that no one wanted to buy. These are the 'toxic assets' that people talk about now: bad loans rooted in the decision of US mortgage providers to provide home loans for consumers that were not adequately solvent, with such loans being then converted into bonds and other securities and being traded in a way that, in effect, spread their poison throughout the financial system. As a result, finance capital increasingly had trouble securing the short-term loans that they needed to stay afloat; and thus, for many companies, a crisis of liquidity opened up, as they became unable to borrow to meet their day-to-day needs. This was the background to last week's events, a process that had been unfolding slowly for more than a year.
One irony of recent events was that the American financial system's liquidity crisis took place in a world awash with money. The excess savings of China and other Asian countries, as well as that of the petro-economies, means that globally their is lots of money sloshing about (it is very fortunate for the US that China is not prepared to sell its holdings of US government Treasury bills and bonds; were such to happen, the crisis would be infinitely worse, becoming, no doubt, one of global capitalism). However, increasingly, US investment banks and non-bank financial institutions had a difficult time accessing that money as the awareness of their toxic assets grew. Growing legions of sovereign wealth funds, who at first seemed the most likely corporate partners to solve the crisis, balked when confronted with the true extent of what was going on; hence, the Korea Development Bank walked away from Lehmann Brothers, sealing its fate. In this way, overleveraged US finance generated the foundations of an economic panic amongst global finance capital.
Last week was one of high drama. After the rescue of Fannie Mae and Freddie Mac the previous week, the US government ended up guaranteeing almost half the mortgages in the US. However, the fun really started on Sunday, when Lehmann Brothers (founded 1850) collapsed and Merrill Lynch (founded 1915) was forced to welcome being bought out by Bank of America at a fraction of the stock market value that it had been worth just weeks before. AIG then required a stringent loan of US$85 billion (with the effect that the US government owns one of the largest insurers in the world). Financial markets started to panic. On Wednesday, the 'flight to safety' was so severe that the interest rate on one-month US Treasury bills turned negative, meaning that finance capital would rather lose money holding a safe asset than invest in financial markets awash with unforeseen toxic assets. The yield on three month Treasury bills that day was 0.02 %, the lowest rate since 1941, before the entry of the US into World War Two. Global finance capital was running for cover.
On Thursday and Friday, the US Treasury had no choice: with the financial system threatening to seize up, the world's central banks pumped US$180 billion into global money markets, the US government pledged US$50 billion to guarantee money-market mutual funds, US Treasury Secretary Hank Paulson unveiled a plan to mop up toxic assets with government money, and in both the US and London the short-selling of stocks is halted. In effect, the US government has socialized the US financial system, to deal with toxic assets whose worth has been estimated to be anywhere between US$500 billion and US$1 trillion. Of course, many of these assets will be sold at a fraction of the value; nonetheless, the cost of this socialization of US finance will run into the billions of dollars. The US government acted to save American finance capital.
Perhaps of all varieties of economists a Marxist economist would understand the causes of the crisis best. US finance capital has become increasingly divorced from the real economy where goods and services are produced. As such, it is increasingly having to slice and dice ever smaller amounts of the surplus value that is produced in the real economy and then redistributed from the productive economy into the financial sector. As it has to slice and dice, it was finding ever-more esoteric ways of trying to make money on top of an asset base that was not fundamentally changing. It was, in effect, a massive Ponzi scheme, and was bound to come crashing down.
Many things are going to change for global finance capital as a consequence of the past week. No doubt other financial institutions may fail. Investment banking is, as a business, finished, and global finance will start to shift back towards using assets based in the real economy as the basis of its activity. Thus, the market for credit derivatives is also finished, for now, and if it is revived, it will be very, very different. There is also little doubt that for the next little while the ability of consumers and firms to access credit will be heavily constrained; the US government has seen its public debt increase substantially with the socialization of US finance, which suggests that increases in US interest rates will be forthcoming, with implications for economic growth in the US economy, because it is so heavily reliant on debt, and for the rest of the world, because it is so heavily reliant on the US economy.
However, the most critical outcome of this past week is that the era of free market fundamentalism, in which is was believed that the system would work best if left to its own devices, has drawn inexorably to a close in the home of capitalism, the US. If the US government believes the only way to save finance capital is to nationalize assets on a scale greater than that witnessed in Russia under Vladimir Putin, then the era of free market capitalism is finished.
We should not be surprised. This past week has highlighted the fact that in deregulated financial markets market-based outcomes are not necessarily the best for society. If they were, there would have been no need for the socialization of US finance. Those who participate in markets are often motivated by private and professional greed, and will try and do what they can get away with, even if regulatory laws are in place. The financial bubble is a clear demonstration of this greed: financiers chased their astronomical bonus payments, and households jumped at the chance to buy something valuable--their homes--that they never thought they could afford because the mortgage providers told them they could afford it. As Adam Smith said, 'people of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public'. Today, Smith might put it thus: markets cannot be trusted to work in the public interest, because they are a function of the legal and social environment within which they are created, and that environment may encourage actions that are detrimental to the public good in the pursuit of private profit. That has happened, recklessly, in the US over the past 5 years. The truth of Smith's insights have once again been revealed this past week.
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