The Global Financial Crisis for Beginners - No. 165
June 19, 2008
The Global Financial Crisis for Beginners
by Jim Stanford, Canadian Auto Workers
No.165, June 19, 2008
For the last year, the world's financial system has been roiled by a cascading crisis of confidence. The consequences so far have included collapsed banks and brokerages, some $250 billion worth of officially declared losses by financial companies, a marked slowdown of real economic growth in several countries, and a recession in the U.S. More ominously, there may be a darker, deeper storm coming. Many observers (both critics of the current system, and its defenders) fear this latest panic might just lead to "the big one": a structural conflagration that produces depression, chaos, and dramatic change.
Personally I'm skeptical of this judgment, and don't think we should get carried away with doomsday prophesizing. The global financial system has survived at least six major crises since the advent of neoliberalism in the late 1970s. Each time the system manages to rebound and regroup - ever more unequal, unbalanced, and distorted, but still viable nonetheless. So I'm doubtful that this particular meltdown is indeed the one that will bring global capitalism to its knees.
Nevertheless, the current crisis is not remotely over, and could get much worse before it gets better. And the events of the past year have proven that the financial system is both structurally unstable and impossibly unpredictable. So whether it causes larger and more disastrous problems or not, the current crisis is a fitting opportunity to challenge the effectiveness and credibility of the whole neoliberal project - not just its financial and monetary policies, but the way it runs the real economy, too (including a failure to foster real capital accumulation, and failures of public finance).
The financial crisis of 2007-08 had its roots in the collapse of a speculative bubble in the U.S. housing market. Average U.S. home resale prices almost tripled in the decade between 1996 and 2006, driven skyward by low interest rates, tax subsidies, and speculation. As with any speculative asset bubble, once the price for an asset starts rising strongly, other investors will buy it solely to profit from that rising price.
A bizarre American phenomenon called "sub-prime lending" added fuel to this fire. Sub-prime mortgages are issued to lower-income home purchasers, who might not qualify for a regular mortgage. Lenders offered mortgages at low introductory rates, luring buyers to stretch beyond their financial means. Few understood that rates would increase dramatically in later years.
Every bubble must inevitably collapse - and this one eventually did, too. The immediate cause is some event that "pricks" the optimism of speculative investors, turning greed to fear and causing them to rush for the exits. In this case, the downturn started with rising foreclosures (especially by lower-income households), combined with increases in U.S. interest rates. Amidst all the subsequent financial carnage, the most immediate victims of the debacle are the two million mostly low-income American families forced from their homes in one of the largest forced evictions in history.
Shock waves from the downturn were amplified and extended by highly sophisticated new financial practices that first arose in the 1980s and 1990s. Gone are the days when home mortgages were issued by some mundane neighbourhood institution (a local bank branch, credit union, or building society) with good local knowledge of housing markets. Clever financial engineers developed creative, often bizarre ways to convert mortgage lending into a sexier, more lucrative arena. Mortgages (and other forms of routine consumer debt) were "securitized." Instead of existing solely as a promise by a home-buyer to pay back the money, a mortgage became a piece of paper that itself can be sold and re-sold (for speculative profit) on financial markets. Ever-more exotic securities, even further removed from the actual home that a real person lives in, were invented - like "credit default swaps" and other hard-to-pronounce derivatives. But the tail came to wag the dog; these new securities are now gigantic speculative markets of their own, worth far more than all the residential homes in the land.
Individual investors, pension funds, and even government agencies around the world invested in the trendy new products. They hoped for a high return on what they thought were secure assets; many had little idea what they were buying. So when the value of sub-prime mortgage securities began to collapse (due to foreclosures and plunging property values), investors around the world felt the pain.
Speculators tend to heavily leverage their investments (using borrowed money to place their bets). This, combined with sudden uncertainty regarding the value of many securities, created a crisis of trust and confidence that spread through the financial system. Banks would no longer lend to each other; hedge funds were no longer allowed to trade on credit; and brokers experienced sudden cash shortages. Eventually, banks and other institutions wrote off large amounts of securitized mortgages as worthless, and some companies collapsed entirely - like Bear Stearns, a major U.S. brokerage, and Britain's Northern Rock (temporarily nationalized, ironically by a fervently pro-market Labour government). The broad deregulation of private finance under neoliberalism contributed to this extraordinary fragility.
Another painful side-effect of the crisis has been a contraction in private credit creation. When private banks issue new loans, the money supply grows, and spending increases; this credit-creating function is essential to economic growth and job-creation. But being private, profit-seeking companies, banks run this system in accordance with their own interests - not society's broader need for growth and opportunity. When bankers are confident loans will be repaid, they push credit aggressively into the economy. When they are fearful of defaults, they pull credit back - even from reliable customers. This is called a "credit squeeze." When bankers are reluctant to issue new loans because of uncertainty and fear, even deep cuts in interest rates may have little stimulative impact on borrowing and hence spending. The whole economy, at this point, is hostage to the self-protective reticence of private bankers.
The broader breakdown of trust and confidence, and resulting squeeze in credit creation, poses the greatest danger. And this is what central banks around the world have been trying to prevent. Led by the U.S. Federal Reserve (still, ironically, the most pro-active, interventionist, and in some way "Keynesian" of all), they've injected hundreds of billions of dollars in short-term loans (or "liquidity") into the banking system. This allows hard-pressed banks to continue regular borrowing and lending. Other emergency measures also help head off further financial collapses - like the Federal Reserve's decision to offer (for the first time since the 1930s) emergency loans to major brokerages.
We should remember that the ups and downs of the "paper economy" (the financial sector, which trades in paper assets but doesn't produce direct, real value) do not always affect the "real economy" (where working people produce things - goods and services - that are actually useful). This disconnect is obvious when the paper economy is booming: record stock markets and financial valuations don't at all translate into jobs or incomes for the rest of us (other than the waiters and nannies who service the personal needs of high-flying financiers). The disconnect is also apparent when the paper economy turns down: the disappearance of even trillions of dollars of ethereal paper value does not necessarily translate into genuine bad news for those of us who make their living through work, rather than wealth. But sudden shocks in financial confidence, and the disappearance of paper wealth, can have indirect negative impacts on the real economy. The transmission of the financial crisis into the real economy (through channels like the decline in U.S. home construction, or a decline in spending by consumers - perhaps solely because they've been shell-shocked by gloomy financial headlines) can convert a paper crisis into a real depression.
At time of this writing (April 2008), international financial officials were worried both about further financial panics, and the growing impact of the sub-prime crisis on the real global economy. IMF officials estimated that total bank and brokerage losses would exceed $1 trillion by the time the crisis runs its course. Only one-quarter of this total has been declared so far by global banks and brokerages, so there's a lot more pain to come. And the IMF also downgraded its estimate for world economic growth - although no major economy, other than the U.S., is currently expected to experience a recession.
The Profit Motive and Private Finance
Fingers have been pointed at unethical U.S. mortgage brokers (for issuing mortgages to families that could not afford them), lazy credit rating agencies (for failing to identify the risks associated with securitized mortgages), and greedy hedge fund investors (for placing risky bets with other peoples' money rather than their own). All these practices contributed to the unfolding of this specific crisis. But this crisis, like those that came before it, is rooted in a deeper and more fundamental problem: namely, a financial system oriented toward maximizing the private profit and wealth of investors, rather than facilitating and lubricating real economic progress for the rest of us:
- Speculation: Investors try to make money off their wealth, following the ancient credo: "buy low, and sell high." This speculative impulse is non-productive: it adds nothing to the output of real goods and services. And it introduces an inherent boom-and-bust instability into financial markets, and (to a lesser extent) into the real economy, as well.
- The Banking Cycle: Private banks issue new loans to customers based solely on the willingness of the customer to undertake the loan (at the going interest rate) and the bank's judgment that the loan will be repaid. An essential economic and social function - credit creation - has been outsourced, with very little social oversight, to private companies interested solely in their own profit. When the cost-benefit calculations of private banks diverge from those of society as a whole (as they very often do), the economy is left with too much credit, too little credit, or (in times of severe crisis) no credit at all.
- Competition: Competitive pressures force banks and brokerages, even those leery of the risks involved, to push the envelope with their decisions - including issuing loans to risky customers, and speculating on riskier derivatives. Competition thus enforces the blind herd mentality which accentuates both the ups and the downs of private finance.
- Innovation: Capitalism is nothing if not creative, and the financial industry has lured some of humanity's smartest minds to focus on the utterly unproductive task of developing new pieces of financial paper, and new ways of buying and selling them. Too bad we can't harness that intelligence and creativity for purposes that are actually useful: finding a cure for AIDS, or preventing climate change.
Despite the finger-pointing at mortgage brokers and credit rates, therefore, the current meltdown is rooted squarely in the innovative but blinding greed that is the raison d'être of private finance. And this critique of the fundamental logic of for-profit finance provides the left with a platform to make a profound critique of that system - as well as developing proposals for far-reaching change.
A Failure of Neoliberalism
If we argue that the current panic is rooted in the fundamental reliance on private profit as the guiding force for financial activity, the left can make an equally fundamental critique (in the wake of this crisis) of the failures of neoliberalism to construct a viable, successful economic order. The current crisis highlights several fundamental failures of the neoliberal order to attain a stable, effective economic order:
- A Failure of Financial Stability: Outrage among the wealth-owning set at the losses incurred in the 1970s (due to rising inflation and falling stock markets) was a crucial ingredient for the rise of neoliberalism later in that decade. And stabilizing the financial system, and protecting investment returns, has been a central goal of neoliberalism ever since. The problem is, despite vanquishing the previously-identified threats to financial capital (by lowering inflation, and dramatically boosting the profitability of real business), the new financial order is clearly just as prone to massive instability and losses (this time self-inflicted) as it ever was during the bad old Keynesian days.
- A Failure of Monetary Policy: Until very recently, it was fashionable speak of a universal "New Consensus" in monetary policy, based on inflation targets and central bank "independence." Modern central bankers seemed to have solved the age-old problem of balancing inflation and unemployment. But this claim of "consensus" turned out to be the economic equivalent of Francis Fukuyama's claim about the "end of history": overstated and ridiculously premature. Yes, inflation in basic consumer prices was controlled, for a while (with the help of Chinese-made products, falling labour costs, and other time-limited changes). But inflation in asset prices remained rampant. And even by traditional measures, neoliberal monetary policy is showing cracks: in the U.S., for example, inflation is now accelerating notably, even as the economy enters recession - exactly as occurred in the 1970s.
- A Failure of Real Capital Accumulation: Today's financial instability is caused, in part, by too much paper capital chasing too little real capital. Despite strong profitability, the investment performance of real business under neoliberalism has been downright sluggish. Net investment in real capital (after depreciation) in the major G7 economies has averaged only about 6% of GDP over the past decade - less than half as fast as during the supposedly troubled 1970s. Moreover, real (non-financial) companies around the world are generating far more cash flow than they reinvest. The result is an unprecedented accumulation of financial wealth by non-financial corporations that only adds to the financial overhang. Deliberate neoliberal constraints on real growth has thus been an important underlying cause of current financial instability.
- A Failure of Public Finance: Even one of the most vaunted "successes" of the neoliberal era - the elimination of chronic government deficits, and the reduction of public debt - has been thrown into question by the sub-prime meltdown. Never mind that the socialization of Northern Rock's debts did more damage to the U.K.'s debt burden than a decade of social spending (pushing the state's debt load above 40% of GDP for the first time since Labour took office in 1997). It turns out that the reduction of government debt under neoliberal cutbacks actually contributed to financial instability. There is no more secure asset than a government bond. But the supply of government bonds declined as government spending was cut and debts reduced. This encouraged (and even forced) investors and institutions to take on riskier assets. Maintaining a "healthy" stockpile of public debt can actually stabilize the financial system.
For these and other reasons, the current crisis is not merely the result of a pointlessly hyperactive, fragile, and unregulated financial system. It reflects a deeper failure of the whole neoliberal program to establish the conditions for productive, effective economic progress.
Fixing the Mess
Global central bankers have been spurred into genuine action by the sheer scale of the present crisis. Led by the Americans, they waded forcefully into the fray - tossing around many tens of billions of dollars of liquidity, bailing out failed brokers, and nationalizing major banks. These actions were prudent, helping to avoid (for now, anyway) a much wider conflagration. The left, however, should demand public accountability from the private institutions which are now receiving an expensive public rescue. And we should expose the stark contrast between the spirit of interventionism which motivates these efforts, and the general "hands-off" mentality which typifies neoliberal responses to other, equally urgent problems (like substandard housing, preventable disease, or environmental degradation).
Calming the current storm is one thing, trying to prevent the next one is another. International financial officials have made very tentative, modest statements about reforming financial regulations to prevent similar abuses and excesses in the future (such as recent agreements by the G7 Finance Ministers and the Basel Committee on Banking Supervision to very modestly strengthen capital adequacy rules and other bank regulations).
The emphasis in these proposals is on oversight and transparency, not genuine regulation. They wouldn't significantly change the hyper-risky behaviour that produced the current meltdown; they would just shine a little more sunlight on it. They wouldn't prevent the rise and fall of future financial bubbles - but they might allow a bit more of the blame to be shifted to the victims (who, in a more transparent world, should have known what they were getting into). And financial interests are already mobilizing to fight even these timid steps toward reregulation.
Genuinely preventing future chaos will require a far more thorough-going overhaul of private finance - guided by a critical understanding of the destructive and irrational incentives created by a deregulated, for-profit financial system. Here are the key areas that should be emphasized:
- Regulation: The most exploitive and dangerous financial practices should be tightly regulated, and in many cases simply prohibited. Regulations should prohibit unethical lending behaviour (curtailing manipulative practices like those that drove the U.S. sub-prime debacle). They should also impose genuine capitalization and reserve requirements; these would force banks (and other institutions which issue financial securities) to keep a significant reserve cushion (consisting of real money or government bonds, not high-risk securities) on account with public regulators to guard against financial panics and collapse.
- Public guarantee system: When investors panic, that panic itself becomes the problem. This is why a strong public guarantee system, protecting at least the core of the financial system (routine consumer and business lending, and non-speculative personal investments up to some "middle-class" threshold), is an essential precondition for financial stability. If savers and investors know their funds are backed up by state guarantees, they have no reason to rush to withdraw their funds when panic strikes.
- Socializing credit creation: At the end of the day, the risks associated with private finance will always be socialized (as they have been in the current crisis), simply because the costs of major financial failures are too severe, and too widely distributed, to tolerate. So why don't we socialize the whole process (or at least part of the process)? In particular, finding more stable and publicly-accountable ways to organize the mundane credit-creation process that is an essential lubricant for real economic progress, but without recourse to the gigantic, expensive paper casino which currently meddles in this function, would be a logical response to the spectacular failure of private finance. In this view, bread-and-butter lending (to home-buyers, consumers, and real businesses) is like a "public good": something we all depend on, but can't trust the private market to reliably supply. Developing public or non-profit vehicles to perform this function (including publicly-owned banks, credit unions, building and mutual societies, and other non-profit vehicles) is thus a credible and timely demand.
- Addressing the real downturn: As financial panic undermines conditions in the real economy (as has already occurred in the U.S.), governments must step in quickly with powerful measures to offset spending weakness and support jobs. The Bush government's "stimulus" package consists almost entirely of tax cuts (surprise, surprise), which will have little impact on immediate spending and production. Lower interest rates, too, have little stimulative power during a private credit squeeze. This situation calls for good old-fashioned direct spending and job-creation by government and its agencies: pumping new demand into the economy through infrastructure projects and public services. If this requires deficit spending, then all the better: the resulting flow of new government bonds will give panicked investors a genuinely safe harbour during the current financial storm.
- Priorizing real investment: Today we can make a strong argument to shift the entire focus of economic policy away from the financial sphere, and back toward the real economy - where we produce concrete goods and services that actually contribute to our collective prosperity. This overarching theme can be reflected in everything from tax proposals (find ways to mobilize more capital in real investment projects, both public and private), to monetary policy (emphasizing a steady, sustainable supply of credit, rather than phony inflation targets), to labour market policy (supplying capable and motivated workers for the jobs our macroeconomic strategy will create). Our argument is strengthened by the failure of the neoliberal model to achieve its supposed core objective. Despite vibrant profits, despite financial deregulation and sophistication, despite globalization, real capitalist businesses invest a shrinking share of their record profits in real capital investments … and our economies are performing sluggishly as a result. In my view, this failure is a gigantic chink in the ideological armour of neoliberalism, that we should exploit to the fullest.
I do not subscribe to the "worse-is-better" school of social change. I hope fervently that the current financial crisis does not spread - because it will leave massive job loss, eviction, and poverty, affecting many millions of people who can least afford it, in its wake. But I also believe this is a moment when socialists can advance a very fundamental critique of the failure of neoliberalism: not just its high-flying financial incarnation, but the very essence of its economic project. The needless, dramatic crisis afflicting the global financial system proves that the neoliberal project has gone badly awry. And we can be thinking very big thoughts indeed about how to change, and ultimately replace, it.
A version of this article appears in the current edition of Red Pepper, a most excellent British magazine of progressive politics: http://www.redpepper.org.uk/.