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With repeated government bailouts of profit-seeking, loss-avoiding financial companies in USA, the very heartland of global capitalism, we have arrived at the end of an era of unquestioned faith in the magic of free markets, says economist Aseem Shrivastava
"Our entire economy is in danger…The market is not functioning properly. There has been a widespread loss of confidence, and major sectors of the country's financial system are at risk of shutting down. The government's top economic experts warn that, without immediate action by Congress, America could slip into a financial panic." -- President George W Bush in a televised speech on September 24, 2008 Such is the reigning blackmail from the highest pulpits. The moment that countless millions around the world may have waited for may just be around the corner. Finance capitalism is in possibly mortal trouble, though perhaps not before extracting larger pounds of flesh. There has been an earthquake in the world of big league investment banking over the past few weeks. And the tremors refuse to die down. News of bankruptcies and insolvencies arrive virtually every day. In the wake of a historic series of banking disasters, the US government has conducted the largest ever financial bailout of private banks in history – involving no less than $700,000,000,000 (70% of the annual GDP of India). This comes on the heels of two other bailouts in the past month, of the mortgage corporations Fannie Mae and Freddie Mac and of the insurance giant AIG, involving an additional sum of $285,000,000,000. In other words, the state has undertaken to infuse up to a trillion dollars into the financial system in order to prevent it from perishing. And further infusions may become necessary in the future. “The centre of gravity of the economic universe”, in the words of a sceptical senator, has moved to Washington. Free markets could not have failed in a more emphatic fashion. The earthquake has shaken loose the financial pillars of the US economy and, by extension, of the world economy, since so much of the world’s savings are invested in the US, other than the fact that the American consumer is the lynchpin of demand in the global economy. Not many months ago, after the investment banking firm Bear Stearns had collapsed, Clinton’s Economic Advisor and ex-Chief Economist of the World Bank, Larry Summers wrote in London’s Financial Times, in typical expert-speak, “It is not unreasonable to hope that in the US at least, the financial crisis will remain in remission.” Recent events have shown up the myopic follies of the pundits, whose predictions rest on that brittle, vanishing, ever-scarce commodity nowadays: confidence. The fall of the giants Let’s examine the damage so far. The five largest investment banks (unregulated by the Federal Reserve, the US central bank) in the US – Goldman Sachs, Morgan Stanley, Lehman Brothers, Merrill Lynch and Bear Stearns – have all vanished from the landscape during the past six months. During the spring, Bear Stearns had to be bought out by JP Morgan (with backing from the Fed) for something under $30 billion. Recently, Lehman has gone bust altogether. Insolvent Merrill Lynch has sold itself to Bank of America. Anticipating similar big trouble, Goldman Sachs and Morgan Stanley have stepped into the noose of (much more regulated) holding banks voluntarily, in order to cut their costs. There are bailouts and then there are cop-outs. The Chairman and CEO of Goldman Sachs puts a smiley face on what is a cop-out: “Becoming a bank holding company is part of our tradition of quick and effective response to market conditions”, he announces to his clients on the homepage of the firm. A confidence-building statement in desperate times, one might say. Nor is investment banking the only area of finance to be devastated. In early-September, the US government had to bring in special legislation to formally back (to the tune of $200 billion) Fannie Mae and Freddie Mac – the government-created shareholder-owned corporations that buy the majority of US mortgages and sell them as repackaged securities around the world. These are gigantic companies with enormous political influence. They owe $5.2 Trillion (35% of US GDP) in guaranteed debt to their investors. The nagging worry is that their loans in the housing market are largely insolvent. Secretary of the Treasury Henry Paulson had the audacity to ask Congress (successfully) for an unlimited credit line to back the failing mortgage giants in addition to the authority to purchase the companies’ shares. “Panic legislating”, a member of the House Financial Services Committee called the exercise. This is not all. The insurance giant AIG had to be rescued last week. Given its inter-connections virtually with the entirety of the financial system, “it was too big to fail.” It had to be bailed out by the US government for an enormous $85 billion. The government took over 80% of the shares in the failing concern. The biggest insurance business in America has been nationalised at the behest of the self-same people who have been the most aggressive advocates for hands-off, free-market economics all along. To cap the fortnight’s financial disasters, Washington Mutual, America’s largest savings and loans institution, has also folded up. Its assets have been handed over to JP Morgan Chase. Its stock values declined from $45 to $0.16 in a year! This is the largest bank failure in the history of American finance. The latest to fall is North Carolina-based Wachovia, again one of the largest commercial banks in the US. These are all big events, with repercussions for one and all both within and outside the US. The import of these disasters will continue to occupy experts for a very long time. Lehman was over 150 years old, after all, having survived two World Wars and the Great Depression. Merrill Lynch too was a century old. Fannie Mae and Freddie Mac are global giants in the mortgage business. AIG was the largest insurance company – and the 18th largest company – in the world, according to the Forbes list. Washington Mutual was the fourth largest bank in the US before its collapse. No one really knows who else is in the queue for further public bailouts. It should, by rights, spell the end of the era of the reign of putatively ‘free’ markets. But will this happen? It was predicted What explains the financial crises underway in America? The explanation is a long and complex one at one level. At another level, one could say it is merely the nemesis for greed having been allowed to run amok for the better part of a generation. But for any reasonable post-mortem one needs a somewhat more detailed answer. There are three main legs to the explanation. First, the sequence of tax cuts issued to America’s affluent classes under the Bush presidency. Second, a policy of “cheap money” (leading to excess liquidity) followed by the Fed under Alan Greenspan, especially during the second half of his tenure. Third, the deregulation of finance since as far back as the early-1970s has been the undoing of the financial system. Let’s take each of these issues in turn. To begin with, the enormous tax cuts issued to the affluent classes by George W Bush had the consequence of not only transferring resources from the poor to the rich, but also of leaving the latter with surplus cash to play with. The money typically ended up via bank deposits and fund managers in speculative investments in financial markets in the expectation of quick and easy multiplication. This was compounded by a policy of ‘cheap money’ – low and falling interest rates – practiced by the Fed under Alan Greenspan, in the vain hope of raising the real economy’s growth rate. When money was available at ridiculously low rates of interest, financial concerns found it opportune to borrow huge sums for purely speculative purposes and leverage investments in all sorts of areas of the global economy. Recent financial institutions like hedge funds gamble with everything from mortgages and real estate to insurance and commodities (like oil or foodgrains). But the factor overarching all these causes has been the deregulation of finance over the past several decades. Something significant happened to the world economy when in August 1971 the Fed stopped converting dollars into gold (because the Japanese and the Germans had accumulated too much of them, thanks to the success they had in selling their products in America) and the international payments regime moved from one of fixed to floating exchange rates, opening up new possibilities of financial speculation due to new uncertainties in exchange markets, apart from the dollar becoming the reserve currency worldwide. There were successful calls for the deregulation of finance, despite opposition from Keynesian economists like James Tobin, who expressed fears related to future financial instability unless there was a tax placed on purely financial transactions. Needless to say, the sceptics were ignored. Not only did such advice go unheeded, but during the ensuing decades, especially during the 1990s, there was a veritable explosion of financial instruments called ‘derivatives’ – in other words, financial assets not directly linked to any wealth-producing activity, but only derived from it indirectly, through the medium of intermediate financial instruments. Thus, a proliferation of new forms of holding wealth took place (such as the mortgage-backed securities which have generated so much mayhem recently), whose risk-return profiles were based on underlying assets, in turn linked to investments on which they themselves were based, and so on. Investment banks, and later hedge funds, pioneered financial innovations which made portfolios ever more opaque. Not only did clients and buyers rarely understand the risk they were undertaking, even sellers very often did not know the extent of risk underlying the securities and assets they were marketing. There was seriously inadequate information on both sides of the market. This means that even according to mainstream economic theory, operating under the assumption of perfect information (yielding efficient markets), the experiment was fated to fail from the start. Financial disaster was predictable, and predicted by many an observer. The problem with financial innovation, it was rightly argued, was financial innovation itself. Dangers were greatly aggravated by the fact that investment banks and hedge funds operated free of supervision by the Fed. Capital markets were no longer performing their traditional function of managing risk and allocating capital in the most efficient way. Instead they had become avenues for unrestrained speculation and gambling by a new class of upwardly mobile fund managers, whose sole obsession was to maximise short-term returns to themselves and their shareholders. For instance, when Bear Stearns was liquidated in March it owed $30 for every dollar that it held as capital. Fannie Mae and Freddie Mac had $80 of debt for every dollar of capital in their control, before their recent nationalisation! (Commercial banks are not allowed such exposure.) If America was generating even a quarter of the real wealth that investors who put their faith in such firms imagined it to be producing, we would have been living in a radically different world from the one we are faced with. The truth is quite different: money has been made not through real growth but by stripping down assets and by artificially causing asset price inflation. Early warning signals of the financial crises to come had been issued on several occasions in the 1990s. For instance, London’s oldest merchant bank Barings collapsed in 1995, thanks to the financial adventurism of a lone trader, Nick Leeson. Likewise, the enormous perils of the hedge fund business had been exposed by the failure of Long Term Capital Management in 1998, a firm which counted a few Nobel laureates on its board of directors. Anyone in the know over the past decade or more of the growth of financial bubbles has been aware of the dangers underlying the explosion of financial wealth – with such a large purely notional content to it. Reckless investing was encouraged every time laws were relaxed. Financial legislation from earlier times – such as the Glass-Steagull Act of 1933 (prohibiting commercial banks from taking the risks which investment banks were permitted) or the law preventing inter-state bank acquisition – was being undone even in the Clinton years. Things really came to a crunch only when the housing bubble in the US burst in August 2007, with the massive insolvency of sub-prime loans. The housing bubble, to be sure, had been fed and pampered by a Federal Reserve desperate to get the economy to grow fast. Under Alan Greenspan it kept low and falling interest rates in order to keep money cheap and spur investment. However, most of the investment that was forthcoming was in speculative areas, rather than in production. Being the best historical indicator of consumer confidence, it was the American housing market which gave hope to gallantly optimistic policymakers. Till August 2007, year-on-year growth in home prices was of the order of 7-17% p.a. The bubble burst after that, exposing the slew of rash home loans that had been made to ‘sub-prime’ borrowers, with low credit ratings. Since then home prices have continued to fall month by month, at 5-16% p.a. compared to the corresponding month in the previous year. What should have been a limited, low-impact financial disaster under a duly regulated financial system has, however, turned into a contagion which threatens the financial stability of the world capitalist economy no less than the American one. The reason for this is the fact that mortgage giants like Fannie Mae and Freddie Mac have been buying mortgages, packaging and reselling them as asset-backed securities (based on the home loans) the world over. At this point in time, it is estimated that at least 20% of the money owed to these two large firms belongs ultimately to foreigners. The Chinese Central Bank, for instance, is heavily invested in these companies. So the stakes are high not just for the US economy but for the rest of the world as well. Times must be very odd indeed if they are considering breaking down houses (The Wall Street Journal, September 25, 2008) in Florida in order to revive confidence in mortgage companies! By reducing the supply of housing artificially, they hope to lift the housing market (and thereby the hopes and stocks of the mortgage corporations whose money lies trapped in them in ‘sub-prime’ loans). The housing market has been at the root of recent troubles in the portals of high finance. Has capitalism ever been this irrational in the past? The Paulson Plan: Markets on life support “The key here is about protecting the system.” Secretary of the US Treasury, Henry Paulson,
Quoted in USA Today, September 21, 2008 It is not about protecting indebted homeowners and helping them with adjusted mortgages. The crisis managers of the system, led by the Secretary of the Treasury Henry Paulson and the Chairman of the Fed Ben Bernanke, have been arguing aggressively for massive government intervention in the markets ever since the Bear Stearns bailout in March this year. Hastily passed legislation has given Paulson unprecedented powers. This includes, for instance, a blank check from Congress, which can be used any time till the end of 2009, and that allows him (or his successor) to bail out or take over (by buying their shares) Fannie Mae and Freddie Mac, the all but insolvent corporations which are funding the bulk of American mortgage loans. There is every chance that this window will be accessed, given the extent of sub-prime exposure of the two falling giants. Paulson defends his plan thus: “The more flexibility I have, the more confidence that gives to the market…” (Time, August 8, 2008) What happened to market magic? Earlier this week, Paulson and Bernanke succeeded in convincing Congress to pass a bill which obliges the US government (and by default the taxpayer) to buy a huge pile of useless mortgage debt, adding up to $700 billion – so far. The money could have funded decades of social security for all Americans. It could have provided health to everyone in the world’s richest country. Welfare moms can’t be spared a thousandth part of $700 billion – because they need market discipline, otherwise they lose the incentive to work. But finance captains need to be helped out of the mess for which they alone are responsible. Why not let them bleed to death, as true market logic dictates? Wall Street has to be saved from itself. And it is an ignorant public that is being asked yet again to foot the bill. It was Franklin Roosevelt in the midst of the Great Depression in 1933 who had spoken of “throwing the money-changers out of the temple”. How was he to realise that it was always going to be difficult to throw them out if they were also the key financiers of temple-construction? Paulson, like his predecessors (John Snow and Paul O’Neill), was the chairman of Goldman Sachs in his previous job. He is known to have been a generous contributor to Republican Party funds when he led Goldman Sachs. When the public seeks some light from the aspirants to the White House, they encounter plenty of silence, baseless optimism or just vacuous rationalisation, which betrays a lack of understanding of the dimensions of the crisis. For McCain “the option of doing nothing is simply not an acceptable option”. (Free markets, in other words, can’t be trusted.) Obama, for his part, backs the Paulson plan “because Main Street is now at stake”. The largest contributor to Obama’s campaign is Goldman Sachs. Merrill Lynch heads the list of donors for McCain. Both have made for the exits this past fortnight. Tweedledum and Tweedledee. “The Wall Street politbureau” The Americans have obviously perfected the revolving door system between private and public offices, with executives from the financial world typically occupying key positions in the executive branch of the US government. Both the Clinton and the Bush administrations have had Treasury secretaries who ran Goldman Sachs. It is this which makes them exempt the giants from market discipline – because it is ultimately they themselves that they are exempting. When it comes to developing nations, the IMF and the World Bank never tire of hypocritically insisting on “market discipline”, balanced budgets and “austerity”. Meanwhile, the money managers in New York and Washington are allowed to practice “Goldman Sachs socialism”. Their task is to privatise profits and gains and socialise costs, losses and risks. And they are enormously successful at pulling off the trick before a gullible electorate. For this is what the Paulson plan is all about. It is about the public bailing out financial adventurers who took catastrophic risks for the pure lure of lucre. It generates what economists call “moral hazard”. Why after all, would a fund manager learn the hard lesson of financial prudence, when the state is willing to come to his rescue every time he crosses the line and fails to recover his loans, thanks to his own excesses? To be sure, the government did try somewhat to send a signal to the markets by allowing Lehman to fail. But then Lehman is not the only piece of mischief in town, and the exposure of others poses even bigger “systemic risk”. Three days after the Lehman failure, the government bailed out AIG. The giant had feet of clay: the insurer was not insured. Of course not. The interests of the captains of finance have to be protected at all costs. Here is one paragraph from the legislation recently pushed through Congress: "Section 8. Review. Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency." In other words, finance will now be entirely above the law or the publicly accountable executive and no one, howsoever aggrieved, might bring lawsuits against the government. This is the formalisation of the dictatorship of finance. Will the plan work? It is most unlikely, if not impossible. The government’s rescue act can only work if by some miracle the housing market picks up sharply again, restoring confidence all around in mortgage-backed securities, enabling Fannie Mae, Freddie Mac and other holders of bad mortgages to breathe, lightening the load on the federal budget. But the data continues to show continuing sharp declines in home prices. Credit Suisse now expects over 10 million foreclosures of home mortgages in the next few years. There are other reasons why the plan is likely to fail. Highly leveraged institutions (far exceeding the ratio of 12:1 that was the norm till 2004) are not being forced to adhere to stronger disclosure standards, tighter lending norms or to more stringent capital adequacy standards. There is still no discussion of derivatives being regulated through monitored exchanges. In other words, there is yet no bar on reckless lending. (Banks in any case have not, for sometime now, been making the most money from lending for the creation of new physical capital. They have found it far more profitable to strip down existing assets or to inflate their prices artificially.) Nor are there new controls on the interest and charges that finance companies levy from consumers, who will continue to be fleeced, even as the culprits-in-chief for the present impasse “earn their way out of debt.” If consumer confidence falls further in the future as a consequence, it should come as no surprise. If the government represented the interests of citizens – as against bankers – it would have bailed out homeowners (rather than the financial system), adjusting their debt burden downwards to conform better to their ability to pay. It should have been the US government’s first priority to awaken the financial classes (much more so than the homeowners) to economic reality. Debts needed to be written down to what homeowners can actually pay. Instead it has chosen to promote the illusion that the debts are solvent, after all. There is only a problem with the cash flow, once confidence is restored and credit begins to move again, the fundamentals of the economy are strong and growth will resume in due course. Such is the vain hope. How can the plan work on such myths? Breaking ranks, the Dallas Federal Reserve Bank President Richard Fisher says that the bailout "would plunge the US government deeper into a fiscal abyss". He is looking at the other end of things. Where will the money for the bailout come from? There are only two possibilities. Taxes are raised from already severely debt-strapped consumers, aggravating the recession in the real economy and worsening, among other things, the housing market itself (thereby contributing to a vicious cycle). The other alternative is for the government to borrow abroad – since no one is willing to lend at home. But do lenders abroad have confidence in the US economy? Here is a report from Reuters: “Chinese regulators have asked domestic banks to stop lending to US financial institutions in the inter-bank money markets to prevent possible losses during the financial crisis, the South China Morning Post reported Thursday.” If, in another desperate move, the US government starts offering higher interest on their bonds (thereby raising the long-term burden on the taxpayer), it will make the domestic financial crisis much worse – by raising further the cost of borrowing. The truth is that the policy elite of America has actually run out of options – certainly patriotic ones, which would involve due punishment for those whose excesses have precipitated the present crisis, and economic justice for those ordinary citizens who are suffering. Dominated as it is at this point by big investors and financial executives it can do no better than to serve the interests of its own class, making the most of the money-making opportunities presented by the crisis. And if temporary nationalisation is needed for bigger gains in the future, they are willing to punctuate the rhetoric of free markets for a while. We are seeing a new chapter in the privatisation of politics being written. End of neo-liberalism? The more things change, the more they remain the same. Towards the end of a period of history some of its hidden truths have to emerge into the light of day. This is what has happened during the past few weeks with repeated tax-payer-backed government bailouts of profit-seeking, loss-avoiding financial companies. It has become very clear that finance capitalism cannot breathe without the state not merely standing close by as the underwriter of last resort, but also having to intervene frequently with infusions of cash in order to buoy up investor confidence and keep credit channels moving – in an economy in which real wealth is actually not being created. We have arrived at the end of an era in which neo-liberalism – a renewed, unquestioned faith in the magic of free markets – reigned supreme over policy-making the world over. What we notice now is that in the very heartland of global capitalism free markets have failed resoundingly, that too in the very sphere they were meant to be most efficient in: the allocation of capital and the management of risk. We are also seeing how the prodigiously wealthy investor class, never too tired to make even more money, is planning and plotting to capitalise on all the many financial opportunities that the crisis is providing. The lesson is a simple one: all capitalism is ultimately state capitalism. The corporate market economy and the state need each other. Quite distinct from the circular flow of income those undergraduate students learn in macroeconomics classes – in which workers spend in consumer markets the income they earn for their labour – there is a different kind of circular flow that seems to be getting institutionalised between two big American cities. In this far thicker flow, hug sums of money travel in the form of campaign funds to politicians in Washington and return to Manhattan in the shape of even handsomer bailouts whenever the need arises. The more serious lesson is the one that most economists have forgotten today, that the internal dynamics of a free market capitalist economy do not typically enable it to find an equilibrium ensuring full employment of labour and other resources. In particular, the dynamics of financial markets are such that serious crises periodically arise giving rise to indefinite periods of “liquidity preference”, when no one has the confidence that a loan that they extend has any chance of coming back. In such situations the state has to intervene in the economy in various forms. It has to engage in public spending, generating employment and demand in the system. It might also have to take charge of banking. The speedy nationalisation of so many banks and insurance companies in the US calls back from memory the following advice which an economist who has been in unjust disrepute over the past generation had given during the last time that capitalism was in such a tortured condition, in the 1930s: “Let goods be homespun whenever it is reasonably and conveniently possible, and, above all, let finance be primarily national.” John Maynard Keynes, a pariah in the economics profession today, pointed this out in the 1930s. For having failed to heed such advice, the managers of the system may have exposed capitalism to terminal crisis, even as they make new room for reaping greater private benefits. Countries like India must at least learn to stand up to Washington’s so-called multilateral institutions – the IMF and the World Bank – and refuse any lecturing on ‘free markets’ any more. There must be a limit to public hypocrisies. Infochange News & Features, October 2008
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