Cyrus Bina on “Financial Crisis: The Sub-Prime Tip of Laissez-faire and Too-Big-to-Fail Subsidies”

click here to the powerpoint presentation

Bubbles, risk, crunch and war

This 2008 interview with Prof Cyrus Bina is published here for educational purposes only.

Click here to download the interview

Finance, Class and Politics in the European Economic Crisis

Was the German Election a Turning Point?

Courtesy: Socialist Project

The New Farm Owners

Corporate investors lead the rush for control over overseas farmland

GRAIN, October 2009

Click here for the table accompanying this article

With all the talk about "food security," and distorted media statements like "South Korea leases half of Madagascar’s land,"1 it may not be evident to a lot of people that the lead actors in today’s global land grab for overseas food production are not countries or governments but corporations. So much attention has been focused on the involvement of states, like Saudi Arabia, China or South Korea. But the reality is that while governments are facilitating the deals, private companies are the ones getting control of the land. And their interests are simply not the same as those of governments.

"This is going to be a private initiative."

– Amin Abaza, Egypt’s Minister of Agriculture, explaining Egyptian farmland acquisitions in other African nations, on World Food Day 2009  

Take one example. In August 2009, the government of Mauritius, through the Ministry of Foreign Affairs, got a long-term lease for 20,000 ha of good farmland in Mozambique to produce rice for the Mauritian market. This is outsourced food production, no question. But it is not the government of Mauritius, on behalf of the Mauritian people, that is going to farm that land and ship the rice back home. Instead, the Mauritian Minister of Agro Industry immediately sub-leased the land to two corporations, one from Singapore (which is anxious to develop the market for its proprietary hybrid rice seeds in Africa) and one from Swaziland (which specialises in cattle production, but is also involved in biofuels in southern Africa).2 This is typical. And it means that we should not be blinded by the involvement of states. Because at the end of the day, what the corporations want will be decisive. And they have a war chest of legal, financial and political tools to assist them.

 "What started as a government drive to secure cheap food resource has now become a viable business model and many Gulf companies are venturing into agricultural investments to diversify their portfolios."

– Sarmad Khan, "Farmland investment fund is seeking more than Dh1bn", The National, Dubai, 12 September 2009

Moreover, there’s a tendency to assume that private-sector involvement in the global land grab amounts to traditional agribusiness or plantation companies, like Unilever or Dole, simply expanding the contract farming model of yesterday. In fact, the high-power finance industry, with little to no experience in farming, has emerged as a crucial corporate player. So much so that the very phrase "investing in agriculture", today’s mantra of development bureaucrats, should not be understood as automatically meaning public funds. It is more and more becoming the business of … big business.

The role of finance capital

GRAIN has tried to look more closely at who the private sector investors currently taking over farmlands around the world for offshore food production really are. From what we have gathered, the role of finance capital — investment funds and companies — is truly significant. We have therefore constructed a table to share this picture. The table outlines over 120 investment structures, most of them newly created, which are busy acquiring farmland overseas in the aftermath of the financial crisis.3 Their engagement, whether materialised or targeted, rises into the tens of billions of dollars. The table is not exhaustive, however. It provides only a sample of the kinds of firms or instruments involved, and the levels of investment they are aiming for.

Private investors are not turning to agriculture to solve world hunger or eliminate rural poverty. They want profit, pure and simple. And the world has changed in ways that now make it possible to make big money from farmland. From the investors’ perspective, global food needs are guaranteed to grow, keeping food prices up and providing a solid basis for returns on investment for those who control the necessary resource base. And that resource base, particularly land and water, is under stress as never before. In the aftermath of the financial crisis, so-called alternative investments, such as infrastructure or farmland, are all the rage. Farmland itself is touted as providing a hedge against inflation. And because its value doesn’t go up and down in sync with other assets like gold or currencies, it allows investors to successfully diversify their portfolios.

We are not farmers. We are a large company that uses state-of-the-art technology to produce high-quality soybean. The same way you have shoemakers and computer manufacturers, we produce agricultural commodities.”

Laurence Beltrão Gomes of SLC Agrícola,
the largest farm company in Brazil 

But it’s not just about land, it’s about production. Investors are convinced that they can go into Africa, Asia, Latin America and the former Soviet bloc to consolidate holdings, inject a mix of technology, capital and management skills, lay down the infrastructures and transform below-potential farms into large-scale agribusiness operations. In many cases, the goal is to generate revenue streams both from the harvests and from the land itself, whose value they expect to go up. It is a totally corporate version of the Green Revolution, and their ambitions are big. "My boss wants to create the first Exxon Mobil of the farming sector," said Joseph Carvin of Altima Partners’ One World Agriculture Fund to a gathering of global farmland investors in New York in June 2009. No wonder, then, that governments, the World Bank and the UN want to be associated with this. But it is not their show.

From rich to richer

"I’m convinced that farmland is going to be one of the best investments of our time. Eventually, of course, food prices will get high enough that the market probably will be flooded with supply through development of new land or technology or both, and the bull market will end. But that’s a long ways away yet."

– George Soros, June 2009

Today’s emerging new farm owners are private equity fund managers, specialised farmland fund operators, hedge funds, pension funds, big banks and the like. The pace and extent of their appetite is remarkable – but unsurprising, given the scramble to recover from the financial crisis. Consolidated data are lacking, but we can see that billions of dollars are going into farmland acquisitions for a growing number of "get rich quick" schemes. And some of those dollars are hard-earned retirement savings of teachers, civil servants and factory workers from countries such as the US or the UK. This means that a lot of ordinary citizens have a financial stake in this trend, too, whether they are aware of it or not.

It also means that a new, powerful lobby of corporate interests is coming together, which wants favourable conditions to facilitate and protect their farmland investments. They want to tear down burdensome land laws that prevent foreign ownership, remove host-country restrictions on food exports and get around any regulations on genetically modified organisms. For this, we can be sure that they will be working with their home governments, and various development banks, to push their agendas around the globe through free trade agreements, bilateral investment treaties and donor conditionalities.

 "When asked whether a transfer of foreign, ‘superior’, agricultural technology would be welcome compensation for the acquisition of Philippine lands, the farmers from Negros Occidental responded with a general weariness and unequivocal retort that they were satisfied with their own knowledge and practices of sustainable, diverse and subsistence-based farming. Their experience of high-yielding variety crops, and the chemical-intensive technologies heralded by the Green Revolution, led them to the conclusion that they were better off converting to diverse, organic farming, with the support of farmer-scientist or member organisations such as MASIPAG and PDG Inc."

– Theodora Tsentas, "Foreign state-led land acquisitions and neocolonialism: A qualitative case study of foreign agricultural development in the Philippines", September 2009

Indeed, the global land grab is happening within the larger context of governments, both in the North and the South, anxiously supporting the expansion of their own transnational food and agribusiness corporations as the primary answer to the food crisis. The deals and programmes being promoted today all point to a restructuring and expansion of the industrial food system, based on capital-intensive large-scale monocultures for export markets. While that may sound "old hat", several things are new and different. For one, the infrastructure needs for this model will be dealt with. (The Green Revolution never did that.) New forms of financing, as our table makes plain, are also at the base of it. Thirdly, the growing protagonism of corporations and tycoons from the South is also becoming more important. US and European transnationals like Cargill, Tyson, Danone and Nestlé, which once ruled the roost, are now being flanked by emerging conglomerates such as COFCO, Olam, Savola, Almarai and JBS.4 A recent report from the UN Conference on Trade and Development pointed out that a solid 40% of all mergers and acquisitions in the field of agricultural production last year were South–South.5 To put it bluntly, tomorrow’s food industry in Africa will be largely driven by Brazilian, ethnic Chinese and Arab Gulf capital.

Exporting food insecurity

Given the heavy role of the private sector in today’s land grabs, it is clear that these firms are not interested in the kind of agriculture that will bring us food sovereignty. And with hunger rising faster than population growth, it will not likely do much for food security, either. One farmers’ leader from Synérgie Paysanne in Benin sees these land grabs as fundamentally "exporting food insecurity". For they are about answering some people’s needs – for maize or money – by taking food production resources away from others. He is right, of course. In most cases, these investors are themselves not very experienced in running farms. And they are bound, as the Coordinator of MASIPAG in the Philippines sees it, to come in, deplete the soils of biological life and nutrients through intensive farming, pull out after a number of years and leave the local communities with "a desert".

 "Entire communities have been dispossessed of their lands for the benefit of foreign investors. () Land must remain a community heritage in Africa."

– N’Diogou Fall, ROPPA (West African Network of Producers and Peasant Organisations), June 2009

The talk about channelling this sudden surge of dollars and dirhams into an agenda for resolving the global food crisis could be seen as quirky if it were not downright dangerous. From the United Nations headquarters in New York to the corridors of European capitals, everyone is talking about making these deals "win–win". All we need to do, the thinking goes, is agree on a few parameters to moralise and discipline these land grab deals, so that they actually serve local communities, without scaring investors off. The World Bank even wants to create a global certification scheme and audit bureau for what could become "sustainable land grabbing", along the lines of what’s been tried with oil palm, forestry or other extractive industries.

Before jumping on the bandwagon of "win–win", it would be wise to ask "With whom? Who are the investors? What are their interests?" It is hard to believe that, with so much money on the line, with so much accumulated social experience in dealing with mass land concessions and conversions in the past, whether from mining or plantations, and given the central role of the finance and agribusiness industries here, these investors would suddenly play fair. Just as hard to believe is that governments or international agencies would suddenly be able to hold them to account.

 Some companies are interested in buying agricultural land for sugar cane and then selling it on the international markets. It’s business, nothing more”

Sharad Pawar, India’s Minister of Agriculture, rejecting claims that his government is supporting a new colonisation of African farmland, 28 June 2009

Making these investments work is simply not the right starting point. Supporting small farmers efforts for real food sovereignty is. Those are two highly polarised agendas and it would be mistaken to pass off one for the other. It is crucial to look more closely at who the investors are and what they really want. But it is even more important to put the search for solutions to the food crisis on its proper footing.

References

1 – It was not South Korea, but Daewoo Logistics.

2 – See GRAIN, "Mauritius leads land grabs for rice in Mozambique", Oryza hibrida, 1 September 2009. http://www.grain.org/hybridrice/?lid=221 (Available in English, French and Portuguese.)

3The table covers three types of entities: specialised funds, most of them farmland funds; asset and investment managers; and participating investors. We are aware that this is a broad mixture, but it was important for us to keep the table simple: http://www.grain.org/m/?id=266

4 – COFCO is based in China, Olam is based in Singapore, Savola is based in Saudi Arabia, Almarai is based in Saudi Arabia, and JBS is based in Brazil.

5 – World Investment Report 2009, UNCTAD, Geneva, September 2009, p. xxvii. Most foreign direct investment takes place through mergers and acquisitions.

Crisis, the Bankers’ Bailout, and Socialist Analysis/Strategy

Dave Hill

The current crisis of Capital and the current response

In the current juncture, the crisis of capitalism, as in the repeated crises of capital and overproduction and speculation predicted by Marx, capitalists have a big problem. Their profits, the value of the shares and part control of companies by Chief Executive Officers and other capitalist executives (late twentieth century capitalists), are plummeting. The rate of profit is falling, has fallen.

The political response by parties funded by Capital, such as the Democrats and Republicans in the USA, and Labour, Liberal and Conservative in the UK is not to blame the capitalist system, not even to blame the neoliberal form of capitalism (new brutalist public managerialism/ management methods, privatisation, businessification of education, for example, increasing gaps between rich and poor, between schools in well-off areas and schools in poor areas). They have criticised only two aspects of neoliberalism: what they now (and only now!) see as the over-extent of deregulation, and the (obscene) levels of pay and reward taken by ‘the big bankers’, by a few Chief Executive Officers (CEOs).

Not an end to Capitalism or even to Neoliberal Capitalism

Talk of an end to neoliberalism is premature, so is talk of an end to capitalism. Criticism in the mainstream capitalist media and mainstream capitalist political parties is only of the excesses of Capitalism, indeed, only the excesses of that form of capitalism- neoliberal capitalism- that has been dominant since the 1970s, the Thatcher-Reagan years- dominant in countries across the globe, and within the international capitalist organisations such as the World Bank, the International Finance Corporation, the World Trade Organisation.

Premature, too, is talk of a return to a new Keynesianism, a new era of public sector public works, together with (in revulsion at neoliberalism’s- in fact- capitalism’s- excesses) a new Puritanism in private affairs/ private industry.

The current intervention by governments across the globe to ‘save banks’ can be seen as ‘socialism for the rich’, a spreading of the pain and costs amongst all citizens/ taxpayers to bail out the banks and bankers. Side by side with this bailing out of the banks (while retaining them as private- not nationalised institutions!) is the privatisation, and individualisation of pain- the pain that will be felt in wallets and homes and workplaces throughout the capitalist countries, both rich and poor. Already (November 2008) we see in Britain the Conservative Party changing its previous policy of matching Labour’s spending plans for 2010 onwards into a rightward slide- saying that public services will have to suffer, to pay for the cost of the crisis. Capitalist governments throughout the world will, unless successfully contested by class war and action from below, make the workers and their/ our public services, pay for the crisis. So that, once again, the bankers can make their billions, extracted from the surplus value of the labour power of workers.

It is true that finance institutions need government intervention, in order to keep funding loans and mortgages, to prevent banks and finance capital repossessing people’s homes. But under what conditions?

Marxists and left socialists need to lead and support calls and mobilisations for the nationalisation of the banks. In Britain, for example, people such as John McDonnell, the leader of the ‘left’ Labour MPs in Britain, and the LRC (Labour Representation Committee) and Marxist groups such as the Socialist Party and the International Socialist Group and the Socialist Workers Party call for banks to be taken into public ownership (with the SP calling for ‘compensation only on the basis of proven need’), in other words for the nationalisation of finance to be complete and long-term.

But Capital and the parties it funds will, seek to ensure that Capital is resurgent, and that after what they see as this temporary ‘blip’ in capitalist profitability, it will once again confidently bestride the world, though with less of an obvious smirk on its face, and with less obvious flashing of riches. At least for the time being.

In times such as these, of economic crisis and of the inevitable retrenchment, it will be the poor that pays for the crisis, in fact, not just the poor, but the middle and lower strata of the working class.

Controlling the Workers

And who better to ‘control’ the workers, the workforce, to sell a deal – cuts in the actual wage (relative to inflation) and the social wage (cuts in the real value of benefits and of public welfare and social services)- but the former workers’ parties such as the Labour Party, or, in the USA, the party with (as with labour in Britain) links to the trade union movement- the Democrats. So US Capital swung massively behind Obama in the US Presidential election, and it is likely that increasing sections of British Capital will swing behind Gordon Brown and what is still regarded by many as a workers’ party, or at least, the more social democratic of the major parties on offer. Better to control the workers when the cuts do come. And to return to a slightly less flashy form of capitalism- more regulated, but still the privatising neoliberal managerialising, commodifying, neo-colonial and imperialistic capitalism.

Resistance

This is, as ever, subject to resistance and the balance of class forces (itself related to developing levels of class consciousness, political consciousness and political organisation and leadership). Resistance is possible, and will, inevitably grow. Demonstrations, strikes, anger, outrage at cuts, will increase, perhaps dramatically, in the coming period. To repeat, to be successful instead of inchoate, such anger and political activism needs to be focussed, and organised. In such circumstances, the forces of the Marxist Left in countries across the globe, need to put aside decades old enmities, doctrinal, organisation and strategic disputes. In Britain, for example, the Socialist Party, the Socialist Workers party, Respect, the Alliance for Workers Liberty, the Communist Party of Britain, other groups on the Marxist Left, together with socialists within the Labour Party, need to rapidly form a coherent organisation/ alliance and expose the current crisis as a crisis not just of neoliberalism, but of Capitalism itself. And to pose Socialist alternatives. Here, the new anti-capitalist party in France (under the leadership of Olivier Besancenot), coalescing formerly rival groups and individuals, is an outstanding example of a successful regrouping/ regroupement of the Marxist Left. And in Britain, the Convention of the Left could play a coalescing role?

Of course, regroupment by itself just organises current activists and supporters. Regroupment needs to be followed by, accompanied now! by recruitment. At this particular moment in the crisis of capital accumulation and the actual and potential for loosening the chains of ideology/ false consciousness promulgated by knowledge workers in the (witting or unwitting) service of Capital.

Implications for Education Policy of the Current Crisis

Within England there may well be some minor changes following from disenchantment with neoliberalism. Such changes, the changes in recent years promoting more creativity in the curriculum, reducing the burden of tests, have been argued for by unions and by the Socialist Teachers Association (STA) for years.

But changes to restore and go beyond a more democratically accountable, less brutalist, less divisive, less test-driven, less punitive education system, are not yet on the cards. With campaigns and mass pressures they could become so.

But there is nothing inevitable about neoliberal education transmogrifying any time soon into liberal child friendly and/ or socialist education for equality. These need to be fought for, and will need to be part of a wider transformation of social and economic relations in society.

Which is why we can foresee an intensification of right-wing attacks on radical and socialist educators, on critical pedagogues, throughout the capitalist world.

The culture wars, between the ideologies/ belief systems of Marxism and Socialism on the one hand, and the various forms of pro-capitalist ideology: social democratic, liberal –progressive, neoconservative, neoliberal and racist/ Fascist ideologies on the other, will intensify.

Interest in Marxism is growing. More are seeing through the Emperors’ clothes of pro-capitalist politicians, sand their sleight of hand support for Finance Capitalism and Capitalist exploitation of the labour power of workers.

Hence, in these current times, Marxist and radical educators are dangerous. Intimidation, dismissals, public denunciations (there are many cases globally, most recently in Australia and the USA) will increase.

It is a time for civic courage, for hope, for Marxist analysis, for solidarity, for organisation. A united Left could and should display all five.

Dave Hill is Professor of education policy, University of Northampton, United Kingdom.

Global Economic Crisis-IV

Deepankar Basu

Link to Global Economic Crisis-I
Link to Global Economic Crisis-II
Link to Global Economic Crisis-III

The Medium Term Story

The medium term story of the evolving financial crisis begins at the end of the last century. With the bursting of the dot-com bubble at the end of the 1990s, possibilities of a long recession hovered on the horizon. The Federal Reserve, the Central Bank of the US, moved in with the tools of monetary policy to ease the slowdown. The target for the federal funds rate, the key short-term interest rate that the Fed monitors as part of it’s monetary policy tasks, was gradually lowered from over 6 percent per annum to a little below 2 percent within a span of about an year. Lowering interest rates to engineer a soft-landing for a slowing economy is a natural thing to do: reducing the cost of borrowing funds is a key way the Central Bank can affect the level of investment and consumption (especially of durable goods) expenditures and thereby boost the level of aggregate demand in a slowing capitalist economy. With finance in command, this normal and natural move had a perverse effect.

Fed Funds Rate

The effects of the falling federal funds rate gradually cascaded from the short-end to the longer end of the asset market, lowering interest rates on all kinds of contracts. One of the key long-term interest rates affected by this very sensible move of the Fed was the interest rate charged on various kinds of mortgage loans (loans to finance the purchase of homes). With mortgage interest rates falling, consumers not only started purchasing new homes with new mortgage loans but also refinancing their old mortgages. With the demand for mortgage loans increasing, and the increase sustained by a low-interest rate regime, house prices started picking up. Very soon, i.e., within a year or two, economists started noticing a bubble in house prices. There were several indicators of a house price bubble. For instance, the Case-Shiller house price index for 10 US cities – a commonly used price index for houses – increased rapidly since the early 2000s. Even more tellingly, the price-to-rental ratio of houses went through the roof. Between January 2000 and April 2006, the rental of an average house did not increase at all; during the same period, price of an average house increased by about 70 percent, sending the price-to-rental ratio on an upward spiral.

Price-Rental Ratio

The fact that the price-to-rental ratio increased rapidly gave a clear indication that a house price bubble was building up. People were, in other words, purchasing houses not because of the service provided by a house but because of speculative motives. A rough proxy for the value attributed by consumers to the service provided by a house is the rental rate; since this was not increasing, it meant that people were not valuing the real service provided by the house. But prices of houses were shooting up giving an indication of an increasing demand for houses (relative to supply). Most of this demand was clearly arising from speculative motives; many of the house purchases were for the purpose of selling them off at a later date to reap capital gains (i.e., the profit derived from the difference between the selling and the buying price of the asset). Thus, the rise in prices was not driven by “fundamentals” (i.e., increase in the intrinsic value of the service provided by houses) but largely by speculative motives of capital gains; that is precisely what leads to an asset price bubble and that is what happened.

Sub-prime Mortgage Market

A run of a couple of quarters of rising house prices was very soon incorporated into the expectation formation mechanisms of financial markets. As has been observed over and over again in history, rising asset prices very soon creates irrational expectations that prices will keep rising, rising certainly in the foreseeable future if not forever. Such periods of rapidly rising expectations, feeding primarily on itself, have been labelled as “manias” by economists studying periods of asset price boom-and-bust. Prominent examples of such economists are Charles P. Kindleberger and Hyman P. Minsky, coming, as they are, from very different political traditions. In the context of the early twenty-first century US economy, the unprecedented house price bubble created grounds for the emergence of predatory lending and the sub-prime mortgage market. The sub-prime mortgage market was the market for mortgage loans to less-than-creditworthy borrowers at very high interest rates that often came with hidden but onerous terms. (Useful material on predatory lending and the subprime mortgage market can be found here)

A financial innovation that indirectly helped the emerging sub-prime mortgage market and the practice of predatory lending was “securitization”. Securitization, in the context of the mortgage market, meant pooling together hundreds and thousands of mortgage loans together and then selling bonds on that pool of mortgages. Investors buying those bonds – the mortgage backed bonds – received the income stream, both the principal and the interest, entailed by the mortgages as the mortgage borrowers serviced their debt. Securitization required that the entities, usually investment banks like Bear Stearns or Merril Lynch, that were issuing (i.e., selling) mortgage backed securities (the mortgage backed bonds or other kinds of assets backed by the mortgage pool) needed ownership of the pool of mortgages against which those mortgage backed securities were being issued. Thus, the entities that issued the mortgage backed securities went out and bought mortgage loans from the originators of the mortgages, i.e., those who sold the mortgage loan to the borrower, like Country Wide Financial (the largest mortgage seller in the US prior to the financial collapse).

The fact that mortgage loan originators had a market where they could sell off the mortgage loans they had originated created perverse incentives for the originators. Typically mortgage loan originators do a thorough screening to assess the financial background of applicants before making loans. With the emerging market for selling off mortgages, the effort at screening was reduced to zero. Things actually went even further. Since mortgages could be sold off at good prices to the investment banks, the mortgage loan originators had a incentive to start engaging in predatory lending, i.e., push mortgage loans on persons who they knew would not be able to sustain the payments entailed by the loan. Since the originator did not have to bear the risk of failure associated with non-payment of mortgage loans, they had no incentive to make prudent loans. All they had to do was to force some gullible working class person to agree to the sub-prime loan and then turn around and sell it off to some investment bank in Wall Street. Thus, the market for sub-prime mortgages proliferated, driven by rising demand coming from the Wall Street investment banks. And why were investment banks so eager to buy these sub-prime mortgages? To answer this question, let us look a little more closely at the process and results of “securitization”.

Securitization

Securitization is the division, repackaging and dispersal of debt, earning huge fee income for the entity (usually an investment bank) that is undertaking this process. The process starts with some commercial or investment bank buying a swathe of mortgages, some prime, some sub-prime, from smaller financial institutions and pooling them together. Each mortgage, recall, entails a stream of future payments; so the pool of mortgages, entails some specific stream of future payments. Various categories or “tranches” of bonds, arranged according to their risk characteristics, are then issued against the pool of underlying mortgages, i.e., against the stream of future payments entailed by the pool of mortgages. Investors who buy these bonds (mortgage backed securities) then have the claims on the mortgage payments coming through month after month after month; if some mortgage fails i.e., payments stop the lowest category (i.e., most risky) bondholder loses first, the losses travelling up the tier of the bonds.

Let us look at a specific example: Bear Stearns Alt-A Mortgage Pass-Through Certificate. This is how this mortgage backed security worked. Bear Stearns bought 2871 mortgages from different mortgage originators for a total of $1.3 billion; this mortgage pool had mortgages that had been originated in different parts of the US, each worth on average for $ 450,000. Bear Stearns then pooled these diverse mortgages and issued 37 different bonds against that pool of mortgages; these bonds were called the Alt-A Mortgage Pass-Through Certificates. Alt-A stands for a very specific kind of mortgage: a mortgage where the originator does not ask any questions about the financial situation of the borrower before making the loan. It is not even ascertained whether the person taking the loan has a stable employment or not! Two additional players come into the picture: credit rating agencies and insurance companies.

Since many investors had an idea that the mortgage backed bonds were risky investments, they required some “independent” rating agency like Standard & Poor’s or Moody’s to ascertain the riskiness associated with investing in those bonds. This is one of the typical functions of credit rating agencies: to ascertain the riskiness (i.e., risk of default) of bonds and assign a credit rating to it; credit ratings run from AAA/Aaa (least risky) to C/D (in default). There were two problems with the involvement of credit rating agencies in the whole securitization process. First, there was an acute shortage of reliable information about the mortgages in the underlying pool; recall how the mortgages in the pool had originated in very different geographical locations, had been offered to very different income categories of people. Most importantly, very little information was collected about the financial standing of the borrowers (especially in Alt-A mortgages). So, despite their best efforts, the credit rating agencies could not come up with realistic risk assessment of the bonds issued against the pool of mortgages. The second problem was even more serious: a conflict of interest. Who paid the fees to the credit rating agencies? The same investment banks that issued the mortgage backed bonds; thus, there was a real incentive for the rating agencies to underplay the risk and certify most of the bonds as “investment grade”. That is more or less what happened, as we now know.

The other player in the securitization process was an insurance provider; since investment in mortgage backed securities (and other related assets) carried some risk investors wanted insurance against default. The instrument that was used to provide insurance for such transactions was the credit default swap (CDS), a derivative financial instrument. Suppose an investor bought bonds worth $1 million; then, to insure herself against the possibility of default she could buy CDS from some financial firm like AIG on those bonds. The insurance premium that she had to pay, called the CDS rate or spread, was typically in the range of 1-2 percent of the value of the bonds, $1 million in this case. She would thus pay $ 20,000 (if the CDS rate was 2 percent) and the CDS contract would protect her against default for the period of the validity of the contract (typically a few years). In the bonds were to go into default the firm that had issued the CDS would have to pay her the amount of her losses.

There were several problems with the CDS market. First, it was an over-the-counter (OTC) market and did not operate through an exchange; hence the possibility of monitoring or regulating this market were negligible. All the contracts were bilateral contracts and no one other than the two parties to the exchange could, in principle know the details of the contract. Second, unlike traditional insurance contracts, there were no reserve requirements. Thus, the financial entity selling the CDS was not required, by law, to hold any reserves against the CDS issued, unlike traditional insurance. So, if the CDS were to actually come due there was no guarantee that the firm that had issued the CDS would be in a situation to make good it’s side of the contract. Third, the most bizarre aspect of the CDS market was that the investor buying the CDS was not required to hold the underlying assets.

This third aspect is truly incredible and led to a veritable explosion of speculation. Let us think about this for a minute. It meant that if I believed GM would fail three years down the line, an investor could buy $10 million worth of CDS on GM bonds by paying a fee of $200,000 (assuming a CDS rate of 2 percent); and this the investor could do even though she did not hold any GM bonds. If GM actually failed and her bet was correct she could make $10 million on an investment of $200,000, a phenomenal 49 fold return! One could never expect to make such return by actually holding the bonds, and so investors started making huge bets using the credit default swaps instead of investing in bonds and stocks. By the end of 2007, the CDS market had grown to about $ 55 trillion (about 4 times US gross domestic product).

But who bought the asset backed securities? Who bought the CDS? International investors of all kinds. Around the late 1990s, there was an enormous pool of footloose, speculative capital in the global financial arena. The East Asian crisis, the Russian crisis and several other developing country crises freed up finance for investment in the US; and these investors wanted high returns even if that meant holding risky assets. That is precisely what the Wall Street investment banks were busy churning out: highly risky but high-return investments in the form of the asset backed securities and other more exotic assets. Hedge funds, pension funds, sovereign country funds and other large institutional investors lapped up the exotic assets which promised high returns.

But the whole edifice was built on very shaky foundations. This highly-leveraged investment game could remain profitable if either of two conditions were met: (a) mortgage payments kept coming in, and (b) house prices kept moving up. If mortgage payments stopped coming in, the property could be taken over and sold; hence sub-prime mortgages remained profitable investments even when the borrower was almost certain to default as long as house prices kept moving up. In the middle of 2006 house prices stopped rising and foreclosures started piling up; and then the whole process, the whole speculative game, started unravelling.

To the Short-term once again

With the medium term story more or less under our belts, let us return once more to the short term story and ask: why did Bear Stearns fail? Why did Lehman Brothers fail? Why was Fannie and and Freddie nationalized? What caused the near-collapse of AIG? Bear Stearns and Lehman Brothers went under for very similar reasons: they could not keep borrowing to finance their positions. Towards the end of it’s life, Lehman was rolling over close to $ 100 billion a month to finance it’s investments in real estate, stocks, asset-backed securities, bonds and other financial assets. When news of foreclosures started pouring in, investors became convinced that Lehman had big holes in it’s balance sheet because of it’s exposure to the sub-prime mortgage market. They refused to lend it money; thus it’s cost of borrowing went up, it’s stock prices plummeted and it’s credit rating was dropped. With no other option left, it had to file for bankruptcy on September 15, 2008.

Fannie Mae and Freddie Mac were government supported entities (GSEs) that were created to help low-income homeowners get easy access to the mortgage market. They were meant to guarantee mortgages and was supposed to finance this operation by issuing it’s own bonds which were implicitly backed by the US government. It is now clear that they did not stick to this mandate of theirs. Instead, they used the subsidized loans that they could get from the market (due to the implicit government guarantee) to invest in mortgage backed securities which were backed by pools of sub-prime mortgages. When the sub-prime mortgages started failing, these institutions started losing asset values and it became clear by mid-2007 that they could not sustain the mounting losses. At that point the government stepped in to explicitly guarantee their debt (because it was spread far and wide in the global financial system) which finally culminated in their nationalization.

AIG, the largest insurance company in the US, got into serious trouble because of the credit default swaps that it had written. Around mid-September, about $ 57 billion of insurance contracts that it had written, in the form of CDS, required it to raise serious money. The CDS were all written on bonds linked to pools of sub-prime mortgages and as the sub-prime market worsened, the possibilities of the CDS payouts coming due increased. Because of the possible losses that it could incur, credit rating agencies downgraded AIG. The way the CDS contracts were written, a credit downgrade required AIG to demonstrate that it was capable of making good on it’s contracts; this required it to immediately “post collateral” to the tune of $ 15 billion; if it failed to post collateral, it would be considered bankrupt. Since it did not have that amount of reserves and could not borrow from a tightening credit market, it had to approach the Fed for funds.

Bubble bursts: Delevarging and Deflation

An aspect of the whole build-up that made the unravelling especially painful was the stupendous amount of leverage in the financial system. When the bubble was inflating every investment was so hugely profitable that investors borrowed heavily for investing. This was especially true of the investment banks whose leverage (i.e., ratio of debt to equity) was about 30:1 by 2007; thus, for every dollar of equity these institutions had borrowed 30 dollars. And a large part of the borrowing was at the shortest end of the market. This meant that the investment banks had to continuously borrow from the market (usually roll over their debt) in order to keep financing their assets and investments. This made the system extremely fragile because any serious problem would lead to painful deleveraging (i.e., forcibly reducing debt by various means often involving serious financial loss) and possibly even asset price deflation.

As foreclosures picked up speed, house prices started moving down. Defaults on mortgage payments and falling house prices meant that the mortgage backed securities started losing value. Often this meant that when lenders came knocking on the doors for their funds, assets had to be sold at short notice and at low prices to cover debt payments coming due. A rush to sell assets often led to a further fall in the value of assets, even those not linked to mortgage backed securities, leading to worsening balance sheets in wider and wider circles. With bonds losing value and even facing default, the CDS contracts suddenly started coming into effect. Since CDS issuers like AIG had not held any reserves for such contingencies, they got into greater and greater difficulties as bonds insured by CDS contracts started failing.

Falling assets values meant that financial firms faced greater difficulty in borrowing from the market, partly because the value of assets that they could offer as collateral had already fallen. Falling collateral value often lead to increasing costs of borrowing in terms of higher interest rates. Difficulty is accessing funds gives another push to sell off assets to cover debt payments, taking the spiral one step down. Deleveraging and an asset price deflation and a string of failures and rescues really led the financial system, in mid-September 2008, to completely lose faith in itself; it is this severe loss of confidence that manifested itself in the credit freeze, the center piece of the short-term story.

(To be continued.)

Global Economic Crisis-I

Deepankar Basu

The global economic crisis currently underway is, by all accounts, the deepest economic crisis of world capitalism since the Great Depression. It is necessary for the international working class to understand various aspects of this crisis: how it developed, who were the players involved, what were the instruments used during the build-up and what are it’s consequences for the working people of the world. This understanding is necessary to formulate a socialist, i.e., working class, response to these earth shaking events. In a series of posts here on Radical Notes, I will share my understanding of the on-going crisis as part of the larger collective attempt to come to grips with the current conjuncture from a socialist perspective, to understand both the problems and the possibilities that it opens up.

The Big Story

The current crisis can possibly be fruitfully understood if measured against different time scales: the short-term, i.e., in terms of days and weeks; the medium-term, i.e., in terms of months and years; and the long-term, i.e., in terms of decades. This analytical compartmentalization into three different time periods is useful because it demonstrates how long-term trends silently but inexorably created the conditions for the medium-term problem to explode into the short-term problem that has buffeted the economy since mid-September, 2008.

In the short-term, the current financial meltdown is a severe credit crisis, a situation whereby financial institutions have become unwilling or unable to lend and borrow among themselves thereby freezing the flow of credit in the entire economic system; this credit freeze is largely fuelled by a serious loss of faith in financial institutions and in the financial system as such and came to the fore most forcefully in the middle of September, 2008. It is also possible that the credit freeze, and the underlying loss of faith, might explode into a full-blown banking crisis: banking panic leading to run on even healthy and solvent banks.

In the medium-term, the crisis is the unravelling of a stupendously leveraged speculative bubble on real estate that built itself up for about seven years from the beginning of this decade (and century); this speculative bubble was mediated by fancy financial instruments fashioned by Wall Street, running all the way from sub-prime mortgages, asset backed securities (ABS) and mortgage backed securities (MBS), collateralized debt obligations (CDO) to credit default swaps (CDS); this speculative bubble led up to and culminated, when it finally burst in the middle of 2007, in the credit crisis that the US, and gradually the global, economy finds itself in.

From a long-term perspective the present crisis is, of course, more than just about Wall Street and finance and banking; it is a full-blown crisis of the neoliberal turn in capitalism inaugurated the 1970s. Neoliberalism (or the neoliberal counterrevolution) was a response to the structural crisis of capitalism that emerged in the late 1960s. It was a response from the point of view of the upper fraction of the capitalist class, a fraction especially dominated by financial interests. The neoliberal counterrevolution ushered in a capitalism firmly under the sway of finance capital; the neoliberal policy turn was geared towards breaking the power of labour vis-a-vis capital that had gradually built up during the two decades after World War II. The result was stagnant real wages, slow but growing productivity, and hence growing profit incomes especially of the financial sector, increasing financialization and a deregulated economy for finance to operate in.

Stagnant wages created the demand for debt from a working class used to growing consumption spending; huge profit incomes and the shredding of all regulation on finance created the supply. The result was a growing role of debt in the lives of the working class which, over time, led to a huge debt overhang on the entire economy. As the ratio of outstanding debt to income rose, with stagnant incomes for the majority, the financial fragility of the entire system increased; and it is this systemically fragile financial architecture that finally cracked under the weight of the bursting housing bubble. Thus, the long-term build-up of debt in the US economy resulting from the neoliberal counterrevolution, which increased the financial fragility of the system, created the conditions in which the bursting of various asset price bubbles could lead to a severe credit crisis and loss of faith in the entire financial system.

Impact on the Real Economy

Real GDP figures released by the US Bureau of Economic Analysis (BEA) on October 30 indicated that the US economy was in the midst of a slowdown even before the financial storm hit the world economy in the middle of September. Real GDP in the US contracted at an annual rate of 0.3 percent for the third quarter (i.e., for the months of July, August and September), led by a sharp fall in consumer spending. The financial storm, comprising a severe credit crisis and even a possible banking crisis, will only deepen the slowdown and might even push the US and the rest of the world into a prolonged and painful recession, possibly even a decade long L-shaped recession like the one that Japan witnessed during the lost decade of the 1990s. In such a scenario, fixing the financial mess, dealing with the credit freeze, averting a possible run on the commercial banking system and restoring confidence in the financial system will not be enough to prevent a plunge into a deep, prolonged and painful recession; addressing the credit crisis is necessary but not sufficient to deal with the grave crisis in the real sector. An aggressive fiscal intervention by the US government and other governments around the world, in terms of direct expenditure on goods and services, will be necessary to prevent the slide into a prolonged recession. It is in the interests of the working class to push for such intervention even as it works towards re-building it’s political, social and economic institutions.

(To be continued.)

Worse than They Want You to Think – A Marxist Analysis of the Economic Crisis

 Andrew Kliman

In the past few weeks, since we announced this talk, recognition has increased substantially that the United States, and now the world, are caught up in the most serious financial crisis since the Great Depression.  Because Marxists are famous for “predicting five out of the last three recessions”, I need to point that the term crisis does not mean collapse, nor does it mean slump(recession, depression, downturn).  While the US is probably in the midst of a recession, the downturn has been – thus far – a relatively mild one. For instance, payroll employment has fallen nine months in a row, but the total decline, 760,000, is well less than half of the decline that occurred during the first nine months of the last recession, in 2001, which itself was relatively mild.

In contrast to this, a crisis is a rupture or disruption in the network of relationships that keep the capitalist economy operating in the normal way.  The present crisis is characterized above all by an acute crisis of confidence that loans will be repaid, which has in turn caused an acute crisis of liquidity – an official at the Boston Fed recently termed it a “liquidity lock” – the inability of businesses to get cash for their short-term, day-to-day needs.  Some major credit markets have been essentially “frozen”; which means that lending has been dropping rapidly or even coming to a halt.  But the business sector depends crucially on credit, not only to finance new investments, but just to get from today to tomorrow.  General Electric, for instance, has to produce before it can sell, so in the meantime it regularly borrows heavily by issuing commercial paper in order to pay its suppliers and workers.  If it doesn’t obtain credit, the workers don’t get paid and the suppliers can’t pay off the debts they owe, and so on.  So the economy would be in danger of complete collapse if this situation were to persist for any length of time.

Now, many liberals and leftists have told us that the $700 billion-plus bailout was not needed, or that it is meant to provide windfall profits to the financial industry, or that the money could be spent differently, for instance to protect homeowners against foreclosure, or invest in infrastructure.  But the crisis is much worse than they want you to think, and that’s because they’ve been focusing on the wrong issues.  They’ve focused on the slump – which is not yet terribly severe and which can perhaps be dealt with in many different ways – and/or on the bank failures and bankruptcies in the financial sector.

The really acute, immediate crisis, however, the one that could lead to outright economic collapse, is the crisis of confidence that has caused the liquidity lock.  These liberals and leftists have proposed no alternative policies to deal with this crisis, and that’s because, if one wants to save the capitalist system, there basically aren’t any alternatives that differ, except in the details, from what the Treasury and the Fed and foreign governments are now doing – namely making the liquidity flow, the cash flow, especially by the Fed stepping in to become the lender of last resort in the commercial paper market and by the Treasury twisting the arms of the banks to take the bailout money and then turn around and lend it out.  There’s only one alternative to crisis of confidence and the liquidity lock that differs from this in more than details – a new, human, socio-economic system, socialism.

Fig 1

I want to illustrate some of what I’ve been talking about above by looking at a couple of graphs.  I haven’t found decent data on the decline in the volume of short-term lending, so I’m forced to try to illustrate the problem by looking at interest-rate figures.  Figure 1 is the so-called TED Spread, the difference between the rate of interest that a bank can get by lending to another bank for 3 months (the 3-month LIBOR in terms of US dollars) and the rate of interest it can get by lending to the U.S. Treasury for 3 months.  Lending to the Treasury is safer.  So the difference between these rates, the TED Spread, is essentially a measure of the willingness or unwillingness to take on risk – the extra interest a bank demands before it will take on the extra risk of lending to another bank instead of lending to the U.S. government.

Through the 1st third of last month, the TED Spread was slightly more than 1 percentage point, which is already about double its usual level.  But after the government had to take over Fannie Mae and Freddie Mac, and Lehman Bros. was allowed to collapse, and the government had to buy AIG, and so forth and so on … the spread rose and, after temporarily declining a bit, kept rising and rising, reaching over 4.5%, until last week, when the most recent of the bailout measures and other emergency measures were announced.  As of today, as a result of the bailout and related measures, it had fallen back down, to below 3%.

Fig 2

Figure 2 is the interest rate on 4-week Treasury bills.  Again, for financial institutions, lending to the U.S. government in this manner is safer than putting the money in the bank, because the bank might fail and, until very recently, big institutions’ deposits in the banks weren’t government-insured.  And it’s safer than buying short-term commercial paper.  So when they became afraid to lend to private entities, financial institutions became willing to obtain ridiculously little interest by lending to the U.S. government.  The greater the fear of private-sector lending, the lower the interest rate they were willing to accept.  And so the interest rate on 4-week T-bills has been, again and again, next to nothing for much of the past month.  For instance, much of last week, it was 5 hundredths of 1 percent, meaning that, if you bought a $10,000 T-bill, 4 weeks later, you’d earn 42 cents interest.  But this is what institutions have been willing to do with their cash, because they’ve been so afraid of the alternatives.  (The latest figure, not shown above, is that the interest rate has risen to 0.42%, as the bailout and related measures begin to restore confidence.)

Now let’s consider some of what’s been coming from the left.  In the Oct. 27, 2008 issue of The Nation (pp. 4 – 5), the historian Howard Zinn wrote,

“It is sad to see both major parties agree to spend $700 billion of taxpayer money to bail out huge financial institutions that are notable for two characteristics:  incompetence and greed. …

“A simple and powerful alternative would be to take that huge sum of money, $700 billion, and give it directly to the people who need it. Let the government declare a moratorium on foreclosures and help homeowners pay off their mortgages. Create a federal jobs program to guarantee work to people who want and need jobs”.

This is all well and good, and these are measures worth fighting for to help working people as the slump in the economy worsens.  But how do they address the crisis of confidence and the liquidity lock?   Of course, one could say, “forget trying to restore confidence,” but that is basically to say, “forget trying to save capitalism,” and Zinn didn’t say that.

Barbara Ehrenreich, the well-known writer and erstwhile revolutionary socialist, at least faced the fact that what is on the line is the capitalist system itself, not just incompetent and greedy and huge financial institutions.  She recently opined that there’s no alternative to capitalism “ready at hand,” so she hopes it survives the current crisis:  “I’m hoping that capitalism survives this one, if only because there’s no alternative ready at hand.  At the very least, we should get some regulation and serious oversight out of any bail-out deal ….” (Huffington Post, Oct. 1, 2008)

And then there’s the left-liberal economist Dean Baker, who was for the bailout before he was against it.  On Sept. 20, he wrote,

“There is a real risk that the banking system will freeze up, preventing ordinary business transactions, like meeting payrolls. This would quickly lead to an economic disaster with mass layoffs and plunging output.

“The Fed and Treasury are right to take steps to avert this disaster. … there is an urgency to put a bailout program in place ….” (“Progressive conditions for a bailout,” p. 243.  Real-world Economics Review, No. 47)

In this statement, Baker characterizes the liquidity lock and its implications much in the manner that I characterized it earlier.  But then, 9 days later, he reversed course:

“The bail-out is a big victory for those who want to redistribute income upward. It takes money from school teachers and cab drivers and gives it to incredibly rich Wall Street bankers. …

“This upward redistribution was done under the cover of crisis, just like the war in Iraq. But there is no serious crisis story. Yes the economy is in a recession that is getting worse, but the bail-out will not get us out of the recession, or even be much help in alleviating it.” (“Wall St held a gun to our heads”)

Portraying the bailout as a program to make the rich richer, Baker says correctly that it won’t do much to alleviate or end the recession.  But that doesn’t mean its purpose is to make the rich richer, either.  What about the system’s need to getting the liquidity flowing again – which he was acutely aware of 9 days before?

Well, Baker says, the government can just take over the banks:  “In the event the banking system really did freeze up, then the Federal Reserve would step in and take over the major banks.”  But the government must either take over the banks by buying them, which brings us back to a bailout costing hundreds of billions of dollars – or more, depending on how extensive the nationalization is.  Or the government can take over the banks without compensation.  That’s a lovely way of dealing with a lack of confidence on the capitalists’ part.  And it’s a lovely way of getting credit flowing again.  In order to lend, banks, even nationalized banks, need people and institutions to lend to them and/or invest in them.  But I know that I wouldn’t want to lend to or invest in any institution that has shown a willingness to expropriate without compensation.  Once again, of course, one can say, “forget trying to restore confidence and forget the sanctity of property rights” – in other words, “forget trying to save capitalism” – but Baker didn’t go there.

I want to turn now to the roots of this crisis.   My view is basically that the crisis has its roots in the economic slump of the 1970s, from which the global economy never fully recovered – not in the way in which the destruction of capital in and through the Great Depression and World War II led to a post-war boom.  Policymakers here and abroad have understandably been afraid of a repeat of the Great Depression. So they’ve continually taken measures to slow down and prevent the destruction of capital (a plummeting of the value of capital assets as well as physical destruction of capital).

But the destruction of capital is not only a consequence of an economic slump; it is also the mechanism leading to the next boom.(1)  For instance, if there’s a business that can generate $3 million in profit annually, but the value of the capital invested in the business is $100 million, the rate of profit is a measly 3%.  But if the destruction of capital values enables a new owner to acquire the business for only $10 million instead of $100 million, the new owner’s rate of profit is a more-than-respectable 30%.  That’s a tremendous spur to a new boom.

But such a massive destruction of capital as took place in the Depression and then in World War II hasn’t taken place, and so there’s been a partial recovery only, brought about largely through

(1) declining real wages for most workers and other austerity measures, as well as exporting the crisis into the 3d world, and

(2) a mountain of debt – mortgage, consumer, government, corporate – to paper over the sluggishness and mitigate the effects of the declining real wages.

Because of this excessive run-up of debt, there have been persistent debt crises.  These will continue until

(a) sufficient capital is destroyed to once again make investment truly profitable.  (The present crisis may well end up being this moment.).  Or

(b) there’s such a panic that lending stops and the economy crashes, ushering in chaos or fascism or warlordism or whatever, or

(c) capitalism is replaced by a new human, socialist society.

Bubbles are thus, according to the above, an inevitable result of efforts to “grow the economy,” by means of debt, faster than is warranted by the underlying flow of new value generated in production. The more sophisticated and widespread the credit markets, the greater is the degree to which “forced expansion” (Karl Marx, Capital, vol. 3, Chap. 30; p. 621 of Penguin ed.) can take place, but also the greater the degree of ultimate contraction when the law of value eventually makes its presence felt. So a bubble is kind of like a rubber band stretching and snapping back.

Figure 3 depicts what’s meant by a bubble.  Imagine that demand for assets such as homes or stock shares increases, without a corresponding increase in new value being produced.  This causes the prices of these assets to rise; and on paper, people’s and businesses’ wealth increases, so they now have the means to borrow more, and they may become “irrationally exuberant”; and all of this leads to a further increase in demand, and so forth and so on.

Fig 3

The debt-induced bubble that’s resulted in the present crisis is of course the housing sector bubble.  Paradoxically, it came about because of the weakness of the U.S. economy. First stock prices plunged sharply as the “dot.com” stock market bubble burst. Then the economy went into recession in 2001, and it was weakened further by the 9/11 attacks later that year. In order to allay the fears of financial collapse that followed the attacks, the Fed lowered short-term interest rates. Even after the recession ended a couple of months later, employment kept falling, through the middle of 2003, so the Fed kept lowering short-term lending rates. For three full years, starting in October of 2002, the real (ie inflation-adjusted) federal funds rate was actually negative (see figure 4). This allowed banks to borrow funds from other banks, lend them out, and then pay back less than they had borrowed once inflation was taken into account.

This “cheap money, easy credit” strategy created a new bubble. With stock prices having recently collapsed, this time the flood of money flowed at first largely into the housing market. Loan funds were so ready to hand that working class people whose applications for mortgage loans would normally have been rejected were now able to obtain them.

Fig 4

As Figure 4 shows, the trajectory of the mortgage borrowing to income ratio during the 2000-4 period is an almost perfect mirror image of the trajectory of the real federal funds rate. This is a clear indication of the close link between the explosion of mortgage borrowing and the easy credit conditions. And with new borrowing increasing so rapidly, the ratio of outstanding mortgage debt to after-tax income, which had risen only modestly during the 1990s, jumped from 71 percent in 2000 to 103 percent in 2005 (see figure 5).

Fig 5

The additional money flooding the housing market in turn caused home prices to skyrocket. Indeed, total mortgage debt and home prices (as measured by the Case-Shiller Home Price Index) rose at almost exactly the same rates between start of 2000 and the end of 2005 – 100 percent and 102 percent, respectively.

Those of us who attempt, following Marx, to understand capitalism’s economic crises as disturbances rooted in its system of production – value production – always face the problem that the market and production are not linked in a simple cause and effect manner. As a general rule, it is not the case that particular disturbance in the sphere of production causes an economic crisis. Instead, what occurs in the sphere of production conditions and sets limits to what occurs in the market. And it is indisputable that, in this sense, the US housing crisis has its roots in the system of production. The increases in home prices were far in excess of the flow of value from new production that alone could guarantee repayment of the mortgages in the long run. The new value created in production is ultimately the sole source of all income – including homeowners’ wages, salaries and other income – and therefore it is the sole basis upon which the repayment of mortgages ultimately rests.

But from 2000 to 2005, the rise in after-tax income was barely one third of the rise in home prices. This is precisely why the real-estate bubble proved to be a bubble. A rise in asset prices or expansion of credit is never excessive in itself. It is excessive only in relation to the underlying flow of value. Non-Marxist economists and financial analysts may use different language to describe these relationships, but they do not dispute them. Indeed, it is commonplace to assess whether homes are over or under-priced by looking at whether their prices are high or low in relation to the underlying flow of income.

Now, some players in the mortgage market did realise that something was amiss but nonetheless sought to quickly reap lush profits and then protect themselves before the day of reckoning arrived. But there was a good reason (or what seemed at the time to be a good reason) why others failed to perceive that the boom times were unsustainable: home prices in the US had never fallen on a national level, at least not since the Great Depression.

So it was “natural” to assume that home prices would keep rising. This assumption served to allay misgivings over the fact that a lot of money was being lent out to homeowners who were less than creditworthy, and in the form of risky subprime mortgages. Had home prices continued to go up, homeowners who had trouble making mortgage payments would have been able to get the additional funds they needed by borrowing against the increase in the value of their homes, and the crisis would have been averted.

Even if home prices had leveled off or fallen only slightly, there probably would have been no crisis. In the light of the historical record the bond-rating agencies assumed, as their worst case scenario, that home prices would dip by a few percent. It was because of this assumption that they gave high ratings to a huge amount of pooled and repackaged mortgage debt (mortgage backed securities) that included subprime mortgages and the like. Today these securities are called “toxic” – very few investors are willing to touch them. But if the bond-rating agencies had been right about the worst case scenario, the investors who thought that they were buying safe, investment grade securities would indeed have reaped a decent profit.

As we now know, however, the bond-raters were wrong, massively wrong, and thus there has been a massive mortgage market crisis.  According to the latest Case-Shiller Index figures, between the peak in July 2006 and July of this year, US home prices fell by 19.5 percent.  And because the mortgages were pooled and resold as mortgage-backed securities, the mortgage market crisis has spread throughout the financial system and become a generalized financial crisis.

I now want to say a bit about who or what is to blame.  We’re hearing a lot about greed, but capitalists are always greedy.  But we don’t always have massive crises.  So what explains the fact that we have one now?

There’s also a lot of talk about lax regulation and insufficient regulation.  I know of no better answer to this notion than the answer recently given by Joseph Stiglitz.  In a Sept. 17 article, “How to prevent the next Wall Street crisis” , Stiglitz, a Nobel Laureate and former World Bank chief economist, proposed a six-point program chock-full of regulations and laws.  But he then acknowledged:  “These reforms will not guarantee that we will not have another crisis.”  So why the title “How to prevent the next Wall Street crisis”?

Stiglitz went on explain why his proposed reforms are no guarantee:  “The ingenuity of those in the financial markets is impressive. Eventually, they will figure out how to circumvent whatever regulations are imposed.”  Yes.  So why the 6-point program?

He then wrote, “But these reforms will make another crisis of this kind less likely, and, should it occur, make it less severe than it otherwise would be.”  Hmm.  If the financial markets will eventually circumvent whatever regulations are imposed, then why isn’t another crisis equally likely with these regulations as without them? And why won’t it be as severe with them as without them?

Finally, I want to say a few words about the significance of the various government interventions we’ve seen this year – the government’s forced dismantling of Bear Stearns, the nationalization of Freddie Mac, Fannie Mae, and AIG, and the bailout money that’s being used to partially nationalize the banking system.  Some commentators portray this, as I noted earlier, as an effort to make the rich richer.  Others depict it as some sort of progressive turn, an ideological shift away from the “free market.”  I think both notions are seriously mistaken.

What we are witnessing is a new manifestation of state-capitalism. It isn’t the state-capitalism of the former USSR, characterized by central “planning” and the dominance of state property; it is state-capitalism in the sense in which Raya Dunayevskaya used the term  to refer to a new global stage of capitalism, characterized by permanent state intervention, that arose in the 1930s with the New Deal and similar policy regimes (Marxism and Freedom, Humanity Books, 2000, pp. 258ff.).  The purpose of the New Deal, just like the purpose of the latest government interventions, was to save the capitalist system from itself.

Because many liberal and left commentators choose to focus on the distributional implications of these interventions – who will the government rescue, rich investors and lenders or average homeowners facing foreclosure? – let me stress that I mean “save the capitalist system” in the literal sense. The purpose of these interventions is not to make the rich richer, or even to protect their wealth, but to save the system as such.

Consider the takeover of Bear Stearns.  It was in serious trouble but there were other ways of dealing with its troubles than by the government forcing it to be sold to JP MorganChase.   Had Bear Stearns been able to borrow from the Fed, it could have overcome the cash-flow problem it faced.  But the Fed waited until the following day to announce that it would now lend to Wall Street firms. Or, if Bear Stearns had been allowed to file for bankruptcy, it could have continued to operate, and its owners’ shares of stock would not have been acquired at a fraction of their market value. Instead the Fed forced it to be sold off.

Thus the takeover was definitely not a way of bailing out Bear Stearns’ owners. Nor was the Fed out to enrich the owners of JP Morgan Chase. (The Fed selected it as the new owner of Bear Stearns’ assets because it was the only financial firm big enough to buy them.) Instead the Fed acted as it did in order to send a clear signal to the financial world that the US government would do whatever it could to prevent the failure of any institution that is “too big to fail”, because such a failure could ultimately bring the financial system crashing down.

And consider the government’s rescue of Fannie Mae and Freddie Mac.  This came about because of a sharp decline in their share prices.  But the government didn’t rescue them in order to prop up the price of their share prices.  Their share prices continued to decline after the rescue plan was announced, precisely because the government’s motivation was not to bail out their shareholders. Indeed, the shareholders aren’t receiving any money from the government. Only those institutions and investors that lent to them are being compensated for their losses, and the government had been seriously considering not compensating some of these lenders (the holders of subordinated debt).  Just as in the Bear Stearns case, the point of the intervention was to restore confidence in the financial system by assuring lenders that, if all else fails, the US government will be there to pay back the monies that are owed to them.

The new manifestation of state-capitalism we are witnessing is essentially non-ideological in character.  Henry Paulson is certainly no champion of government regulation or nationalization.  But at this moment of acute systemic crisis, ideological scruples simply have to be set aside.  The be-all and end-all priority is to serve the interests of capitalism – capitalism itself, as distinct from capitalists.  As Marx noted, “The capitalist functions only as personified capital …. [T]he rule of the capitalist over the worker is [actually] the rule of things [capital] over man, … of the product [capital] over the producer” (Results of the Immediate Process of Production,” in Penguin ed. of Capital, vol. 1, pp. 989 – 90, emphasis in original).  The goal is the continued self-expansion of capital, of value that begets value to beget value, the accumulation of value for the sake of the accumulation of value – not for the sake of the consumption of the rich.

Of course, we are indeed witnessing a movement away from “free-market” capitalism, and back to more government control and even temporary ownership.  But this is a pragmatic matter rather than an ideological one.  There’s nothing inherently progressive about it.  The government is simply doing what it must, whatever it must, to prevent a collapse of the system.

The recent state capitalist interventions are perhaps best described as the latest phase of what Marx called “the abolition of the capitalist mode of production within the capitalist mode of production itself”. There is nothing private about the system any more except the titles to property. As I’ve been stressing here, the government is not even intervening on behalf of private interests: it is intervening on behalf of the system itself. Such total alienation of an economic system from human interests of any sort is a clear sign that it needs to perish and make way for a higher social order.

The current economic crisis is bringing misery to tens of millions of working people. But it is also bringing us a new opportunity to get rid of a system that is continually rocked by such crises. The financial crisis has caused so much panic in the financial world that the fundamental instability of capitalism is being acknowledged openly on the front pages and the op-ed columns of leading newspapers. Great numbers of people are already searching for an explanation of what has gone wrong.  Many of them may be ready to consider a whole different way of life, and many more will be ready to consider this as the recession in the real economy deepens.  Revolutionary socialists need to be prepared, not just prepared to organize, but prepared with a clear understanding of how capitalism works, and why it cannot be made to work for the vast majority. And we need to get serious about working out how an alternative to capitalism – one that is not just a different form of capitalism – might be a real possibility.

Andrew J Kliman is Professor of Economics at Pace University (US). This talk was delivered at The New SPACE (The New School for Pluralistic Anti-Capitalist Education), New York City, October 21, 2008. It is to be posted on the New SPACE website .  An audio recording which includes the discussion that followed will be made available soon.  The talk draws in part on Andrew Kliman, “Trying to Save Capitalism from Itself” (April 25)  which is also available at The Hobgoblin and Andrew Kliman, “A crisis for the centre of the system” (Aug. 23) published in International Socialism, No. 120 ).

Note:

(1) Addition, October 22:  In discussion following this talk, questions were raised about how my discussion of capital destruction is related to Marx’s “law of the tendential fall in the rate of profit.”  To address this, let me quote from pages 30-31 of my book Reclaiming Marx’s “Capital”:  A refutation of the myth of inconsistency (Lexington Books, 2007):

“what Marx meant by the “tendency” of the rate of profit to fall was not an empirical trend, but what would occur in the absence of the various “counteracting influences,” such as the tendency of the rate of surplus-value to rise.

“He singled out one of these counteracting influences, the recurrent devaluation of means of production, for special consideration. Like the tendential fall in the rate of profit itself, and the tendency of the rate of surplus-value to rise, the devaluation of means of production is a consequence of increasing productivity. Capitalists incur losses (including losses on financial investments) as a result of this devaluation; a portion of the capital value advanced in the past is wiped out. In this way (as well as by means of their tendency to cause the price of output to fall), increases in productivity tend eventually to produce economic crises. Yet since the advanced capital value is the denominator of the rate of profit, the annihilation of existing capital value acts to raise the rate of profit and thus  helps to bring the economy out of the crisis” (see Marx [Capital, vol. 3], chap. 15, esp. pp. 356-58, 362-63 [of the Penguin ed.]).

Perspectives on the US Financial Crisis

Sam Gindin and Leo Panitch

It is time to take stock. The centrality of the American economy to the capitalist world – which now literally does encompass the whole world – has spread the financial crisis that began in the U.S. housing market around the globe. And the emerging economic recession triggered in the U.S. by that financial crisis now threatens to spread globally as well.

Capitalism has had an incredible run – politically and culturally as well as economically – since the stagflation crisis of the 1970s. The resolution of that crisis required, as economists put it at the time, ‘reducing expectations’ of the kind nurtured by the trade union militancy and welfare state gains of the 1960s. This was accomplished via the defeats suffered by trade unionism and the welfare state since the 1980s at the hands of what might properly be called capitalist militancy. This was accompanied by dramatic technological change, massive industrial restructuring alongside labour market flexibility and the over – all discipline provided by ‘competitiveness.’

That discipline brought with it an enormous increase in economic inequality, the spread of permanent working class insecurity and the subsumption of democratic possibilities to profitable accumulation. But this did not mean capitalism was no longer able to integrate the bulk of the population. On the contrary, this was now achieved through the private pension funds that mobilized workers savings, on the one hand, and through the mortgage and credit markets that loaned them the money to sustain high levels of consumer spending on the other. At the centre of this were the private banking institutions that, after their collapse in the Great Depression, had been nurtured back to health in the postwar decades and then unleashed the explosion of global financial innovation that has defined our era.

The question begged by the current crisis is whether capitalism’s capacity to integrate the mass of people through their incorporation in financial markets has run out of steam. That the fault line should have appeared in ‘sub-prime’ mortgage loans to African-Americans is hardly surprising – this has always been the Achilles’ heel of working class incorporation into the American capitalist dream. But an economic earthquake will actually only result if there is a devaluation of working class assets in general through a collapse of housing prices and the stock and bonds in which their retirement savings are invested.

The state and financial crises

We are by no means there yet. The role being played to prevent just this by the Federal Reserve, very much acting as the world central bank in light of the global implications of a U.S. recession, should once and for all dispel the illusion that capitalist markets thrive without state intervention. It was through the types of policies that promoted free capital movements, international property rights and labour market flexibility that the era of free trade and globalization was unleashed. And this era has been kept going as long as it has by the repeated coordinated interventions undertaken by central banks and finance ministries to contain the periodic crises to which such a volatile system of global finance inevitably gives rise.

The Fed has repeatedly poured liquidity into its financial system at the first sign of trouble. The question is whether the capacity of the system to go on integrating ordinary Americans though the expansion of investor and credit markets in this way has reached its limit. This was indeed suggested by the Bush administration’s sudden (non-military) Keynesian turn with a $150 billion fiscal stimulus. However, that fiscal stimulus at the federal level may be undone at the state level, especially with municipal government cutbacks, given their massive dependence on property taxes. The way financial institutions that specialized in selling risk insurance on municipal bonds were enveloped in the credit crisis has further compounded the problem. This indeed brings to mind the extent to which it was municipal governments that were on the front lines of the Great Depression.

But while the U.S. may very well move into a recession, which even when it ends may mark the beginning of a new era of slower growth, this is very different from a Depression. While there is no doubt that mortgages in black communities and for the working poor more generally will be tightened, it seems most likely that banks, competing for markets, will continue to extend credit to working families more generally. we need to remember that the top twenty per cent and their families are extravagant consumers. While growing inequalities are grotesque, the left has consistently underestimated the extent to which the rich can sustain overall spending. The ‘correction’ in the dollar (alongside the strength of U.S. manufacturing in the higher-tech sectors) has already led to offsetting growth in markets abroad; U.S. exports have been growing at double-digit rates over the past few years.

Finally, the U.S. state may revive its capacities for substantive infrastructural spending, if only to stimulate the construction industry now that the housing boom is over. Indeed, even from the perspective of competitiveness and accumulation there is a long-neglected need to rebuild U.S. infrastructure – as the collapsed levies of New Orleans and the collapsed bridges of Minneapolis dramatically showed. The type of state intervention that brought us financial globalization is not well suited to this, but this crisis may finally force some renewal of state capacities in this respect, even within the overall framework of neoliberalism.

Finance and Neoliberalism

There is an understandable tendency on the left to take hope in capitalism’s current dilemmas. The extreme liberalization of finance (and along with it the era of neoliberalism) seems discredited. Finance today appears as no more than high-flying speculation – absurdly wasteful and ultimately not sustainable. U.S. corporations remain profitable, but with the credit crunch, who will buy the goods? Discredited as well, it therefore appears, is the U.S. capacity to keep its own house in order, never mind lead the process of globalization. Yet before we assume that the openings created by this crisis place us on the verge of a matching new oppositional politics, we need a more careful reading of our times. While the new openings provide the space for a new politics, we need to soberly appreciate the problematic link between such openings and a radical response.

To begin with, as immoral and irrational as finance might seem, financialization has been absolutely essential to the making and reproduction of global capitalism. Second, the growing consensus that finance must be re-regulated is hardly an attack on finance or neoliberalism more generally. Rather, it is about the engineering of finance so it can continue to be ‘innovative’ in the service of both itself and non-financial capital. Third, whatever problems the U.S. currently faces, its dominance will not fade because of a crisis in housing or a lower exchange rate; it does us no good to underestimate the staying power of the American capitalist empire.

It is not only finance but capitalism in general that rests on speculation. Behind a new firm or a new product rests the ‘speculation’ that it can be sold at a cost and price that generates profit. Behind the distinction between finance and the ‘productive sector’ is therefore something else: the notion that finance speculates in pieces of paper, not in providing goods or real services; it is a parasitic drain on the economy, not a constructive addition to it.

The problem with this line of thinking is that it mistakes what is rational from the perspective of certain moral criteria with what is rational within capitalism. The financial system is necessary to capitalism’s functioning. The discipline finance has imposed in the neoliberal era on particular capitalists and workers has forced an increase in U.S. productivity rates by way of increased exploitation, the more efficient use of each unit of capital, and the reallocation of capital to sectors that are most promising – all from the standpoint of profits, of course.

The penetration by American finance of foreign countries and the inflow of foreign capital into the U.S. has given the U.S. access to global savings, shored up its role as the greatest global consumer and reinforced the U.S. state’s power and options. Especially important, financial markets have come to provide non-financial corporations with mechanisms for managing their risks, and comparing and evaluating diverse investment opportunities in a highly complex global economy. Absent this role, globalization – at least to the extent we have experienced it – would not have been possible. Finally, as emphasized earlier, the ‘democratization’ of American finance has given workers access to finance as savers and debtors, thereby contributing to their integration into, and dependence on, each of capitalism and finance.

This does not mean that the explosion of finance is not a highly contradictory process. Highly volatile financial markets inevitably generate financial crises. Rather, it shifts the question from whether financialization is irrational to whether its contradictions can be managed insofar as the crises can be contained. What working classes do in this context will be crucial to answering this question.

The Dialectics of Regulation

Finance cannot exist without regulation and the U.S. financial sector, even before the latest crisis, was the most heavily regulated of any section of the U.S. economy. In fact, the dynamics of finance cannot be understood apart from how regulation shapes financial competition, how banks and other financial institutions try to escape or reshape that regulation, and the state’s subsequent counter-responses. The current dilemma for American regulatory institutions lies in how to re-regulate finance so as to overcome its costly and dangerous volatility without undermining finance’s needed innovative capacity.

We need to be clear that this is about re-engineering finance to strengthen capital accumulation, not control it in the name of a larger public interest. To place democratic regulation of finance on the agenda would require asking: ‘regulation for what purpose?’ and so would mean going far beyond finance itself. It would mean raising the fundamental question of social control over investment and therefore get to the heart of power in a capitalist society.

In the context of the failed promises of the past quarter century and the current crisis, to see the above issue go completely unmentioned in the Democratic primary debate may not be surprising given the absence of even a trade union campaign around this, but it bespeaks an impoverishment of American politics that in fact goes all the way back to the New Deal. The issue of economic democracy that had been placed on the political agenda alongside the New Deal’s public infrastructure projects was set aside for the remainder of the century after the FDR administration’s self-described ‘grand truce with capital’ in the late 1930s.

It will, therefore, not do to resort to the abstractions and obfuscations of calling for ‘re-regulation’ or a ‘new, new deal.’ It is the undemocratic power of private control over investment that needs to be put on the agenda.

American Empire in Crisis

Four particular aspects of the limited fall-out from the present crisis demand more serious reflection on the left. First, the fact that this crisis surfaced in the context of strong profits and low debt loads in the non-financial sector is important, and this accounts for the limited damage thus far.

Second, it is notable that despite the IMF calling this the most serious banking crisis since the Great Depression, we have not seen a series of banks failures. This is certainly linked to the interventions of the U.S. Fed, but it also speaks to the strength of private U.S. financial institutions. In no other country could such a crisis have unfolded without massive financial bankruptcies.

Third, it is especially worthy of note that no major state saw an opportunity in the crisis to challenge or undermine the American state. Rather, their integration into global capitalism meant that they identified this crisis as their crisis as well. They effectively recognized the U.S. central bank as the world’s central bank and cooperated with it in coordinating internationally repeated provision of liquidity to the banks. As in the previous instances of financial crises during the 1980s and 1990s, this reproduced and extended the American state’s leading role in managing global capitalism.

The fourth, and most important factor is the remarkable ‘imperial flexibility’ the U.S. has by virtue of the weakness of its working class. Had, for example, U.S. workers insisted on higher wages to compensate for rising food and oil prices and the devaluation of their homes and taken advantage of the competitive space offered by a falling dollar, the Fed would have had to cope with the fear of inflation and this might have meant higher rather than lower interest rates. And that could very well have aggravated the crisis and risked a financial meltdown. But rather than the working class demanding more, it in fact showed restraint or, in the case of the autoworkers, accepted the greatest concessions the union has ever made.

The more important question is, therefore, not the economics of crisis but its politics. How will the working class respond to the crisis? If credit continues but becomes more costly; if the loss of private pensions, negotiated health care, and the devaluation of homes force people into having to reduce consumption to shore up their savings; if food and oil prices leave less discretionary spending – if this is the near-term future, will workers rebel? Or will workers once again tighten their belts to preserve what is left from their past gains? And if frustrations are expressed politically, will the politics be limited to a longing for the good-old days before the crisis or before Bush?

Absent what Alan Sears, at the recent Great Lakes Graduate Students Conference at York, called ‘an infrastructure of resistance’, any opposition that does surface is most likely to be localized and contained rather than built on. A coherent alternative is no just a set of economic policy proposals but a political movement that can develop the popular appreciation and capacities for radical democratic control over investment. There should be no illusion that a recession, or even a depression, will necessarily bring the issue of economic democracy back onto the U.S. political agenda. It would require a transformation of American politics to do so – and that, like the current economic crisis, would as well have global implications.

Sam Gindin teaches political economy at York University.
Leo Panitch teaches political economy at York University and is editor of The Socialist Register.

Courtesy: The Bullet

Should the Financial System under Capitalism be Regulated?

Deepankar Basu

A view that is very popular among the votaries of capitalism rests on the alleged efficiency of the financial markets of a “well functioning” capitalist economy. Financial markets, it is claimed, provide the prime mechanisms for channeling funds from savers to the most efficient investment projects, thereby increasing the overall efficiency of the economy. Lack of well-developed financial markets are often interpreted as markers of underdevelopment and economic stagnation. That this is not always the case, that financial markets are unusually prone to “irrational exuberance”, that financial booms and busts are part of the regular functioning of financial markets if often forgotten by this fundamentalist viewpoint.

A more nuanced version of this view is marked by a more measured view towards financial markets. Proponents of this view start by asserting that the financial system is composed of two parts: financial markets and the web of interdependent financial institutions. They recognize the fact that financial markets, by themselves, are often unable or unwilling to perform several important functions (like collecting, processing and disseminating reliable information about borrowers; providing liquidity services; offering deposit and check-writing facilities) required for the smooth functioning of an advanced capitalist economy. Hence, they recognize the important role of institutions, especially financial institutions (like commercial banks, insurance companies, mutual funds, etc.), within the architecture of advanced capitalism. But very often they also go on to assert that the financial system works best if left to itself; that government intervention in the financial system creates unnecessary inefficiencies. When confronted with the evidence of endemic instability of the financial system, they argue that crises and problems have led, over the years, to the development of a host of institutions that are capable of dealing with such episodes; it is both unnecessary and undesirable for the State to regulate the financial system, they claim.

A closer look at the history of the financial system in the US – the leading capitalist nation today – will demonstrate that such a view is seriously misleading; the government has always had to intervene to put the financial house in order. In fact one can go further and assert that the financial system cannot properly function without supervision at crucial moments by the State, if not constant supervision. Let me illustrate this with three well-known historical instances when the State had to step in to deal with the endemic instability of the financial system in the US. These historical instances are important, apart from illustrative purposes of this article, for at least two more reasons. One, they are the defining interventions in the financial system of the US; the financial system as we know it today has been largely shaped by these interventions and the institutions created at those moments. Two, they destroy the facile opposition that is often constructed, both by the Right and even some on the Left, between private capital and the State; the State is an institution created to protect the interests of capital as a whole even though, on occasion, it has to act against some capitals (some firms or industries or even some sectors of the economy). These instance demonstrate clearly that even when the State acted against some financial firms or sectors it was doing so to save and strengthen the capitalist system.

The first major instance of government intervention stands at the very foundational moment of the modern financial system in the US. The unregulated banking industry in the US led to massive bank failures in the late 19th century: waves after waves of bank failures where savers lost their deposits and lenders could not borrow to meet their needs; this led the Congress to create the Federal Reserve System (the Central Bank of the US) in 1913.

Within less than two decades we come to the second major intervention: creation of the FDIC. In the late 1920’s, the US economy was into the biggest downturn it had ever faced: the Great Depression. During this traumatic period, there were thousands of bank failures again (along with a huge stock market crash) and confidence in the whole financial system was greatly eroded. The Congress again stepped in to create the FDIC (Federal Deposit Insurance Corporation) which was meant to deal with the problems that the unregulated banking industry could not handle: bank runs.

The third major intervention (also made around the time of the Great Depression) had been to restrict competition in the banking industry (i.e., to force some form of branching restrictions across geographical regions) and also to restrict the areas into which a commercial bank could enter (basically to separate commercial and investment banking to prevent conflict of interest).

The last instance of government intervention is important because over the last few decades, these laws and the supporting institutions have been generally nibbled away at. For instance, the Glass-Steagall Act of 1933 had created a “wall” separating commercial and investment banking; from the 1970s onwards the growing power of finance has been continuously trying to attack and change this very important law. Finally in 1999, the Gramm-Leach-Bliley Financial Services Modernization Act repealed the Glass-Steagall Act!

The effects are already coming to the fore in the form of major banks’ (like J P Morgan Chase’s) involvement in financial frauds and other irregularities (see the Spring 2007 issue of Dollars & Sense). For instance, Chase was one of the banks which had systematically assisted Enron in its accounting frauds. It had also, in its role as an underwriting agent – one of the main functions of an investment bank – sold Enron stocks to the public knowing full well that Enron was in bad shape. This is precisely the kind of “conflict of interest” that the Glass-Steagall Act was meant to take care of. Now that it has been thrown out, we can expect many more instances of such irregularities.

The bottom line is that I do not share in the optimism about the US financial system (which many people seem to harbour), nor do I think that there is any evidence for such optimism. To suggest that the US financial system has managed to take care of the problems of instability is to willfully ignore well-known empirical evidence. Here are a few: the Savings and Loan (S&L) crises through the 1980’s, the wave of bank failures in the late 1980’s, the stock market crash of 1987, the LTCM scandal in 1998 (when the Fed had to step in to bail out a major financial firm), the dotcom bubble and bust, the imminent meltdown in the sub-prime mortgage market …one could go on and on; but let us look a bit more closely at only two of these well-known episodes of financial trouble: the LTCM fiasco and the sub-prime mortgage meltdown currently underway in the US.

LTCM (Long Term Capital Management), a very famous financial firm of the late 1990s in the US had been feted by Wall Street as one of most technologically sophisticated financial firms in existence; after all it had offered close to 40% annual returns for two years in a row and had towering figures from theoretical finance among its founding members. It was a “hedge fund” formed in 1994 and had, among its founder member two Nobel laureates in Economics: Myron Scholes and Robert Merton. Within four years LTCM was on the verge of collapse! More details about the the rise and fall of LTCM can be found here (there are lots of useful references at the end of this article; among others, there is a very nice PBS documentary on the whole episode which is worth watching.)

A little note about “hedge funds” might not be inappropriate at this point. A “hedge fund” is, to be brief and simple, a financial institution which pools the money of a few very rich individuals and then invests it around the world to make huge profits. Membership to hedge funds is not open; it’s stocks don’t trade in the financial markets; it is always very secretive about how it invests and also about who its investors are. Usually the smallest amount of money that is required by an individual to become part of a hedge fund (i.e., an investor who is one of the many whose money has been pooled into the hedge fund) is $1 million. In most cases, it is much higher. If we look at hedge funds from the point of view of ordinary citizens, we cannot escape the well-known (and increasingly well-recognized) fact that they are notorious for creating instability in financial markets, especially in the low and middle income economies. Their huge size and ability to move funds very rapidly gives them undue power and influence over small and medium economies (now even large economies are facing the music of hedge funds), whose macroeconomic stability is severely jeopardized by their investment strategies.

Coming back to the stunning LTCM collapse, it is important to remember that the Federal Reserve Bank of New York had to step in to arrange credit for its bailout. If the Fed had not intervened to bail out the tottering giant, it might have led to a asset price deflationary spiral leading to a string of failing firms and lost jobs and lost output and macroeconomic instability. For the purposes of this essay, it is merely necessary to note that the financial system could not deal with this problem on its own!

Let us now move on to the second story, a story that is still unfolding: the sub-prime mortgage lending crisis in the US. Referring to the sub-prime mortgage meltdown that is currently underway in the US, a recent report by the Centre for Responsible Lending has estimated that more than 1 million low-income families have lost their homes on net (i.e., after accounting for those who have gained home ownership) over the past nine years. Have the banks and financial firms that created this crisis lost much? It is doubtful whether the banks originating the mortgages, the focus of all the attention in the mainstream press, have really lost anything.

Let me remind readers that the “sub-prime” mortgage meltdown refers to the market for mortgage loans (i.e., loans for buying real estate) supposedly for low-income households without good credit histories. The rule of the game, as it evolved over the last decade, was that the house that is bought with the mortgage loan is used as collateral for the loan so that whenever a family fails to make a single monthly payment (there might be a little variation on this), it leads to “foreclosure” and the bank that had made the loan takes possession of the house to recoup its losses.

But why the term “sub-prime”? The attribute of “sub-prime” comes from the fact that most of these loans made on this market are at above-average (much above the market interest rate for mortgages) interest rates and at very onerous terms; the term contrasts this market with the “prime” mortgage market where loans are available at much lower interest rates. In most cases, these “sub-prime” loans are made in bad faith because the concerned families are “convinced” of the suitability of high-interest rate and “coaxed” into the loans at unreasonable terms. More often than not big banks use various kinds of methods to consciously keep out low-income families from the “prime” mortgage market (where they might have got loans at reasonable rates and terms); most of these families, needless to say, are either African-American or Latinos. Once, in this way, these families have been pushed out of the “prime” mortgage market and into the “sub-prime” market, the same banks turn into loan sharks and strip the low-income families to their bones. It is, therefore, hardly surprising that many families are unable to meet the monthly payments of the mortgage and lose their house and most of their life’s savings. That is what has been documented by the Centre for Responsible Lending and that is what is creating havoc in the lives of many working-class Americans.

These are but two small instances of the operation of financial system under advanced capitalism; one can very easily multiply them ad nauseum. The evidence, if one cares to look, strongly suggests that the US (or any other capitalist economy for that matter) will have to learn to live with inescapable instability; these episodes are as much part of life under capitalism as are economy-wide business cycles. Of course, under capitalism, the overwhelming cost of these episodes of financial and other forms of instability will be always borne by the working people. Hence, all political formations claiming to represent the interests of the working people must vociferously argue for the regulation of the financial system without taking recourse to the false opposition between the State and capital.