Collapse of the Colossus And its Aftermath
18 September, 2008. US Treasury Secretary Ben Bernanke put up a sombre face and told the law-makers that if the government did not save the (financial) markets then there might not be any financial markets in the future.
He was speaking the truth. Over 100 mortgage lenders had gone bankrupt during 2007 and 2008. Concerns that investment bank Bear Stearns would collapse had resulted in its fire-sale to JP Morgan Chase in March 2008. The financial crisis hit its peak in September and October. Several major institutions either failed, or were acquired under duress, or were taken over by the government. These included Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, Washington Mutual, Wachovia, Citigroup, and AIG Insurance – establishments deemed “too big to fail”. So the “Emergency Economic Stabilisation Act of 2008”, which sanctioned a whooping $700 billion for rescuing the fat cats of Wall Street through the Troubled Asset Relief Program (TARP), was passed. There was tremendous popular opposition, including that of some 400 economists – two of them Nobel Prize winners. The basic point was that the package transferred huge amounts of public money into the hands of private financiers responsible for the catastrophe instead of punishing them, thus creating a bad precedent, a “moral hazard”, for the future. The bankers’ government paid no heed, naturally.
As the contagion spread at electronic speed to other rich countries (actually the rot had started earlier: in August 2007 French giant BNP Paribas had terminated withdrawals from three hedge funds citing “a complete evaporation of liquidity”), the latter too launched their own bailout packages. A total financial meltdown was thus averted by governments rescuing financial corporations with taxpayers’ money
But how did things come to such a pass?
To put it very simply, titans like Lehman Brothers, AIG Insurance, Fannie Mae and Freddie Mac (the last two Government Sponsored Enterprises) failed because at the hour of need they could no longer raise money from the market to roll over their short-term debt. During 2004-07, the top five U.S. investment banks unscrupulously increased their financial leverage – reporting over $4.1 trillion in debt for fiscal year 2007, about 30% of US GDP for 2007 – which increased their vulnerability to a financial shock.
Being over-exposed to the sub-prime mortgage market and relying too much on derivatives – instruments derived from the performance of some distant asset (hence the generic name “derivatives”) they suffered huge losses and lost the trust of the market. Investors became reluctant to lend money even to these prestigious financial institutions. Failing to meet their obligations, essentially they went bankrupt, though in most cases (Lehman being the most famous exception) they were rescued by the government.
The “sub-prime mortgage market” or “sub-prime loans” refer primarily to housing loans to those who could hardly afford them and in which the initial interest rate was sub-prime (very low) but escalated over the duration of the mortgage, on the assumption that as the borrower progressed career-wise there would be an increased capacity to pay instalments. The sub-prime loan instruments were then “diced and sliced” (i.e. mixed up with other more viable loans) and the resultant derivatives were sold on by the original mortgage institutions to other banks and financial institutions.
Thus emerged a shadow banking system. The new breed of derivatives generated by dicing and slicing of sub-prime and other risky loans were expected to distribute the risks among many financial institutions and thereby minimise the risks shouldered by each.
This strategy allowed financiers to circumvent regulations and generate easy credit by taking high risk bets and offloading the risks on to others. When, with the collapse of the housing bubble and an avalanche of defaults by sub-prime borrowers, the ‘bets’ began to go wrong, the pyramid of deals began tumbling down. More than once during 2007 and 2008 financial authorities in US and other countries sought to stem the tide by helping the crisis-ridden banks and, to a lesser extent, also indebted homeowners. But in vain. The whole process snowballed and led to the September 2008 debacle.
Strange as it may seem now, the high risk strategy involving excessive sub-prime loans and an endless web of securitisation or derivatives-creation was not restricted or regulated by any public or private authorities. Rather, this strategy was praised as a sure way to prosperity – both for the corporations and for the country. Announcing its 2005 Annual Awards – one of the securities industry’s most prestigious awards – the International Financing Review (IFR) said, “[Lehman Brothers] not only maintained its overall market presence, but also led the charge into the preferred space by ... developing new products and tailoring transactions to fit borrowers’ needs. ... Lehman Brothers is the most innovative in the preferred space, just doing things you won’t see elsewhere.”
Yes, Lehman became too smart and that’s why it met the fate it did. Since the epicentre of the devastating earthquake and its aftershocks lay in the financial sector i.e., the credit network, our investigation into the causes of the crisis should begin from here.
Proximate Cause : Overstretched Credit System and Excessive Speculation
At one time the role of credit – of dealers in credit or financiers – was basically to “grease the wheels” of industry and commerce which turned out real goods, infrastructure and services. But gradually their role expanded and today we find them in dual roles: both as accelerators of growth and harbingers of crisis. US experience under the neoliberal order illustrates this very well.
As a strategy to counter the economic slump that started in 1970s, the working people of America were encouraged to keep up their consumption levels with easy credit made available through aggressive credit card promotions, new and reckless mortgage practices, and other means. This policy had a great political benefit too: the enslavement and immobilisation of the proletariat in credit chains. As Lenin showed in the article “Imperialism and the Split in Socialism” long ago, the imperialist bourgeoisie had devised the tactic of creating a stratum of workers’ aristocracy in their countries by bribing the latter with small fragments of super profits earned in colonies, i.e., by paying them relatively better wages. Today they have improved the tactic further. They now give out huge loans while restricting wages, imposing on the workers a modern version of debt bondage and, with that, the ideological enslavement of consumerism
When the “dot-com” or “New Economy” stock market bubble burst in 2000, the US economy went into recession. It was weakened further by the 9/11 attacks. In order to allay the fears of financial collapse, the Federal Reserve lowered short-term interest rates. But 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 (i.e., inflation-adjusted) federal funds rate was actually negative. 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.
The “cheap money, easy credit” strategy created a new bubble – this time based in home mortgages. This “great bubble transfer” involved a further expansion of consumer debt and an enormous profit explosion in the finance sector achieved through extension of mortgage financing to riskier and riskier customers. The collapse into recession was thus delayed no doubt, but at the same time and in the same measure the latter was made more inevitable and more intense.
The following passages from Marx, with a bit of updating as suggested in square brackets, may help us understand why the economic catastrophe started as a credit and money crisis:
“In a system of production, where the entire continuity of the re-production process rests upon credit, a crisis must obviously occur – a tremendous rush for means of payment – when credit suddenly ceases and only cash payments have validity. At first glance, therefore, the whole crisis seems to be merely a credit and money crisis. And in fact it is only a question of the convertibility of bills of exchange [add here the modern credit instruments– AS] into money. But the majority of these bills represent actual sales and purchases, whose extension far beyond the needs of society is, after all, the basis of the whole crisis. At the same time, an enormous quantity of these bills of exchange represents plain swindle, which now reaches the light of day and collapses... The entire artificial system of forced expansion of the reproduction process cannot, of course, be remedied by having some bank, like the Bank of England, [today we would perhaps say the US Federal Reserve] give to all the swindlers the deficient capital by means of its paper and having it buy up all the depreciated commodities at their old nominal values. Incidentally, everything here appears distorted, since in this paper world, the real price and its real basis appear nowhere ...” (ibid, p 490, emphasis added).
Marx also speaks of “a new financial aristocracy, a new variety of parasites in the shape of promoters, speculators and simply nominal directors; a whole system of swindling and cheating by means of corporation promotion, stock issuance and stock speculation” and of “fictitious capital, interest-bearing paper” which “is enormously reduced in times of crisis, and with it the ability of its owners to borrow money on it on the market.” (Capital, Vol. III, p 493). If this sounds contemporaneous, so would the anxiety expressed by the British “Banks committee” – a predecessor of various expert committees and monetary authorities of our day – more than 150 years ago regarding the fact that “extensive fictitious credits have been created” by means of discounting and rediscounting bills “in the London market upon the credit of the bank alone, without reference to quality of the bills otherwise.” (ibid, p 497, emphasis ours).
Junk securities, then, are no invention of the Wall Street-wallahs of our time!
Imperialism as Domination of Finance Capital
The role of credit in the capitalist system as a whole went on expanding and reached a qualitatively new stage with the advent of modern imperialism, a parasitic and decaying system marked by new features like all-round monopolisation, export of capital out-weighing export of commodities, the rise of the financial oligarchy etc. Money capital now metamorphosed into finance capital and attained a much more influential position:
“Imperialism, or the domination of finance capital, is that highest stage of capitalism in which the separation [“of money capital … from industrial or productive capital”] reaches vast proportions. The supremacy of finance capital over all other forms of capital means the predominance of the rentier and of the financial oligarchy; it means that a small number of financially ‘powerful’ states stand out among all the rest.”
“... [The] twentieth-century marks the turning point from the old capitalism to the new, from the domination of capital in general to the domination of finance capital.” (Lenin in Imperialism; emphasis added)
Now what is finance capital? Basically it is the coalescence of bank capital and industrial capital, said Lenin, and today perhaps we should include commercial capital as well. This coalescence, however, internalises a good amount of tensions and contradictions between the different sectors which maintain their special identities and interests. Modern banks, Lenin showed, concentrated the social power of money in their hands, and began to operate as “a single collective capitalist”, and so “subordinate to their will not only all commercial and industrial operations but even whole governments.” Also important in this context was the three-way “personal link-up” between industry, banks and the government.
Elaborating on the new stage, Lenin wrote:
“The development of capitalism has arrived at a stage when, although commodity production still ‘reigns’ and continues to be regarded as the basis of economic life, it has in reality been undermined and the bulk of the profits go to the ‘geniuses’ of financial manipulation. At the basis of these manipulations and swindles lies socialised production, but the immense progress of mankind, which achieved this socialisation, goes to benefit... the speculators.”
This separation of money capital from productive capital and the supremacy of the former continued to grow, with the result that today we see “a relatively independent financial superstructure … sitting on top of the world economy and most of its national units”. That is to say, there is now an “inverted relation between the financial and the real”, where “the financial expansion feeds not on a healthy real economy but on a stagnant one” (Paul Sweezy, “The Triumph Of Financial Capital”, Monthly Review, June 1994).
Credit Explosion and Crisis
The relative weight of the financial sector in the international economy thus increased steadily all through, but very disproportionately since the 1980s, facilitated by neoliberal deregulation and the information revolution. By far the largest and fastest growing component of this sector is made up of speculation and other reckless activities: derivatives trade, hedge fund activities, sub-prime loans and so on. As Martin Wolf of the Financial Times aptly observed, “The US itself looks almost like a giant hedge fund. The profits of financial companies jumped from below 5 per cent of total corporate profits, after tax, in 1982 to 41 per cent in 2007.” According to the Bank of International Settlements, as of December 2007, the total value of derivatives trade stood at a staggering $516 trillion, growing from $100 trillion in 2002. In other words, this shadow economy was 10 times larger than global GDP ($50 trillion) and more than five times larger than the actual trading in shares in the world’s stock exchanges ($100 trillion).
Trade in derivatives and generally in stock and currencies involve the self-expansion of money capital. As Marx had pointed out, making money out of money without going through troublesome production processes has long been a cherished ideal of the bourgeoisie. In recent decades that ideal has been ‘brilliantly’ put into practice.
In the present context, speculation is trade in financial instruments with the goal of making fast bucks; or to be more precise, buying and selling of risks. Commercial banks, investment banks and insurance companies deal in both industrial financing and speculation – in real life the two categories are thus lumped together – but in terms of specific economic role performed they are different. Traditional credit and production-oriented finance capital serves the real economy – agriculture, industries, services, where wealth is produced and people get jobs – whereas speculative capital produces no real wealth.
As we have seen, top bankers in the mid-19th century cautioned about “extensive fictitious credits” and Marx talked of “over-speculation”. John Maynard Keynes in the mid-1930s warned, “Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” (The General Theory of Employment, Income and Money).
Despite the warnings, and whatever the social costs, speculation has been highly rewarded by the state and other institutions of the capitalist class. But why? Because decadent capitalism or imperialism discovered in it one of the most – if not the most – lucrative escape routes from the crisis of overproduction/over-accumulation that resurfaced since 1970s. The 1997 Nobel Memorial Prize in Economic Science was awarded to America’s Robert Merton and Myron Scholes, who had just developed a model for pricing “derivatives” such as stock options. This model or technique was expected to help speculate ‘scientifically’ and reap mega profits safely. In practice, however, the results were not exactly encouraging. Long Term Capital Management – a hedge fund where Merton and Scholes were partners and which worked according to the prized technique – found itself on the verge of collapse within a year the prize was awarded, and was rescued by the New York Federal Reserve.
Not that there was no saner voices around. Early in the 2000s billionaire investor Warren E. Buffett had called derivatives “financial weapons of mass destruction” and in March 2007 Ben Bernanke, quoting Alan Greenspan, warned that the GSEs Fannie Mae and Fred-die Mac were a source of “systemic risk” and suggested legislation to head off a possible crisis. Then in late 2008 George Soros wrote:
“... [The] current crisis differs from the various financial crises that preceded it. ...the explosion of the US housing bubble acted as the detonator for a much larger ‘super-bubble’ that has been developing since the 1980s. The underlying trend in the super-bubble has been the ever-increasing use of credit and leverage. Credit – whether extended to consumers or speculators or banks – has been growing at a much faster rate than the GDP ever since the end of World War II. But the rate of growth accelerated and took on the characteristics of a bubble when it was reinforced by a misconception that became dominant in 1980 when Ronald Reagan became president and Margaret Thatcher was prime minister in the United Kingdom....
“The relative safety and stability of the United States, compared to the countries at the periphery, allowed the United States to suck up the savings of the rest of the world and run a current account deficit that reached nearly 7 percent of GNP at its peak in the first quarter of 2006.
...” This inevitably led to the crash, he pointed out. (The Crisis and What to Do About It, The New York Review of Books, December 4, 2008).
So the ace speculator castigates excessive deregulation and dependence on debts and deficits.
Well, he describes the surface froth all right, but fails to relate it to the underlying crosscurrents that work it up. If we are to do that, we must turn to the author of Capital.