New Internationalist

A meltdown primer

Issue 417

The current financial crisis is not just about greed and deregulation. Leading Asian economist Walden Bello explains.

Is the worst over?

No. There’s no strategy to deal with the crisis, just tactical responses. It’s like the fire department’s response to a conflagration. The recent multi-billion bail-outs are mainly desperate efforts to shore up confidence in the system and to avoid a massive bank run such as the one that triggered the Great Depression of 1929.

Did greed cause the collapse of global capitalism’s nerve centre?

Good old-fashioned greed certainly played a part.

Was this a case of Wall Street outsmarting itself?

Definitely. Financial speculators outsmarted themselves by creating more and more complex financial contracts like derivatives that would securitize and make money from all forms of risk – including such exotic futures instruments as ‘credit default swaps’ that enable investors to bet on the odds that the banks’ own corporate borrowers would not be able to pay their debts! This is the unregulated multi-trillion dollar trade that brought down US insurance giant AIG.

Was it lack of regulation?

Yes. Everyone acknowledges by now that Wall Street’s capacity to innovate and turn out more and more sophisticated financial instruments had run far ahead of government’s regulatory capability. This wasn’t because government was incapable of regulating but because the dominant neoliberal, laissez-faire attitude prevented government from devising effective regulatory mechanisms.

But isn’t something more systemic happening?

Well, George Soros, who saw this coming, says that we are going through a crisis of the ‘giant circulatory system’ of a ‘global capitalist system that is… coming apart at the seams’. To elaborate, we’re seeing the intensification of one of the central crises or contradictions of global capitalism: the crisis of overproduction, also known as over-accumulation or over-capacity. In other words, capitalism has a tendency to build up tremendous productive capacity that outruns the population’s capacity to consume, owing to social inequalities that limit popular purchasing power, thus eroding profitability.

But what does the crisis of overproduction have to do with recent events?

Plenty. But to understand the connections, we must go back in time to the so-called Golden Age of Contemporary Capitalism, the period from 1945 to 1975.

This was a time of rapid growth that was partly triggered by the massive reconstruction of Europe and East Asia after the devastation of World War Two, and partly by the new socio-economic arrangements institutionalized under the new Keynesian state. Key among the latter were strong state controls over market activity, aggressive use of fiscal and monetary policy to minimize inflation and recession, and a regime of relatively high wages to stimulate and maintain demand.

So what went wrong?

This period of high growth came to an end in the mid-1970s, when the centre economies were seized by stagflation, meaning the coexistence of low growth with high inflation, which wasn’t supposed to happen under neoclassical economics.

Stagflation, however, was but a symptom of a deeper cause: the reconstruction of Germany and Japan and the rapid growth of industrializing economies like Brazil, Taiwan, and South Korea added tremendous new productive capacity and increased global competition. Meanwhile social inequality limited the growth of purchasing power, thus eroding profitability. This was aggravated by the massive oil price rises of the 1970s.

How did capitalism try to solve the crisis of overproduction?

Capital tried three escape routes from the conundrum of overproduction: neoliberal restructuring, globalization and financialization.

What was neoliberal restructuring all about?

This took the form of Reaganism and Thatcherism in the North and ‘structural adjustment’ in the South. The aim was to invigorate capital accumulation by first removing state constraints on the growth, use and flow of capital and wealth; and second, redistributing income from the poor and middle classes to the rich on the theory that the rich would then be motivated to invest and reignite economic growth. This formula gutted the incomes of the poor and middle classes. It thus restricted demand while not necessarily inducing the rich to invest more in production. In fact, neoliberal restructuring had a poor record in terms of growth: global growth averaged 1.1 per cent in the 1990s whereas it averaged 3.5 per cent in the 1960s when state interventionist policies were dominant.

How was globalization a response to the crisis?

The second escape route global capital took to counter stagnation was ‘extensive accumulation’ or globalization. This was the rapid integration of semi-capitalist, non-capitalist, or pre-capitalist areas into the global market economy to shore up the rate of profit in the metropolitan economies. It did this by gaining access to cheap labour, new markets and new sources of cheap agricultural and raw material products; and by bringing into being new areas for investment in infrastructure. Integration is accomplished via trade liberalization, removing barriers to the mobility of global capital and abolishing barriers to foreign investment.

Why didn’t globalization surmount the crisis?

This escape route from stagnation has exacerbated the problem of overproduction because it adds to productive capacity. A tremendous amount of manufacturing capacity has been added, for example, in China over the last 25 years and this has had a depressing effect on prices and profits. Not surprisingly, by around 1997, the profits of US corporations stopped growing. According to one index, the profit rate of the Fortune 500 went from 7.15 per cent in 1960-69 to 5.3 per cent in 1980-90 to 2.29 per cent in 1990-99 to 1.32 per cent in 2000-02.

What about financialization?

The third escape route – financialization – became very critical. In the ideal world of neoclassical economics, the financial system is the mechanism by which the savers or those with surplus funds are joined with the entrepreneurs who have need of their funds to invest in production. In the real world of late capitalism, with investment in industry and agriculture yielding low profits owing to overcapacity, large amounts of surplus funds are circulating and being invested and reinvested in the financial sector. The financial sector has thus turned on itself.

The result is an increased bifurcation between a hyperactive financial economy and a stagnant real economy. As one financial executive notes, ‘there has been an increasing disconnect between the real and financial economies in the last few years. The real economy has grown… but nothing like that of the financial economy – until it imploded.’

What this observer doesn’t tell us is that the disconnect between the real and the financial economy isn’t accidental. The financial economy has exploded precisely to make up for the stagnation owing to overproduction of the real economy.

What were the problems with financialization as an escape route?

Investing in financial sector operations is tantamount to squeezing value out of already created value. It may create profit, yes, but it doesn’t create new value. Only industry, agriculture, trade, and services create new value. Because profit is not based on value that is created, investment operations become very volatile and the prices of stocks, bonds, and other forms of investment can depart very radically from their real value. Profits depend on taking advantage of upward price departures from the value of commodities, then selling before reality enforces a ‘correction’. Corrections are really a return to more realistic values. The radical rise of asset prices far beyond any credible value is what is called the formation of a bubble.

Why is financialization so volatile?

With profitability depending on speculative coups, it’s not surprising that the finance sector lurches from one bubble or one speculative mania to another. And because it’s driven by speculative mania, finance-driven capitalism has experienced scores of financial crises since capital markets were deregulated and liberalized in the 1980s.

What about the current bubble? How did it form?

The current Wall Street collapse has its roots in the technology-stock bubble of the late 1990s, when the price of the stocks of Internet startups skyrocketed, then collapsed in 2000 and 2001, resulting in the loss of $7 trillion worth of assets and the recession of 2001-02. The Fed’s loose money policies under Alan Greenspan encouraged the technology bubble. When it collapsed into a recession, Greenspan, to try to counter a long recession, cut the prime rate to a 45-year low of one per cent in June 2003 and kept it there for over a year. This had the effect of encouraging another bubble – in real estate.

As early as 2002, progressive economists such as Dean Baker of the Center for Economic Policy Research were warning about the real estate bubble and the predictable severity of its impending collapse. However, as late as 2005, Ben Bernanke, now Chair of the Federal Reserve Board, attributed the rise in US housing prices to ‘strong economic fundamentals’ instead of speculative activity. Is it any wonder that he was caught completely off guard when the sub-prime mortgage crisis broke in the summer of 2007?

And how did it grow?

Let’s hear it from key market player George Soros: ‘Mortgage institutions encouraged mortgage holders to refinance their mortgages and withdraw their excess equity. They lowered their lending standards and introduced new products, such as adjustable mortgages (ARMs), “interest-only” mortgages, and promotional teaser rates.’ All this encouraged speculation in residential housing units. House prices started to rise in double-digit rates. This served to reinforce speculation, and the rise in house prices made the owners feel rich; the result was a consumption boom that has sustained the economy in recent years.’

The sub-prime mortgage crisis wasn’t a case of supply out-running real demand. The ‘demand’ was largely fabricated by speculative mania on the part of developers and financiers who wanted to make great profits from their access to foreign money that has flooded the US in the past decade. Big-ticket mortgages were aggressively sold to millions who could not normally afford them by offering low ‘teaser’ interest rates that would later be readjusted to jack up payments from the new homeowners.

But how could sub-prime mortgages going sour turn into such a big problem?

Because these assets were then ‘securitized’ with other assets into complex derivative products called ‘collateralized debt obligations’ (CDOs). The mortgage originators worked with different layers of intermediaries who understated risk so as to offload them as quickly as possible to other banks and institutional investors. These institutions in turn offloaded these securities onto other banks and foreign financial institutions.

When the interest rates were raised on the sub-prime loans, adjustable mortgage, and other housing loans, the game was up. There are about six million sub-prime mortgages outstanding, 40 per cent of which will likely go into default in the next two years, Soros estimates. And five million more defaults from adjustable rate mortgages and other ‘flexible loans’ will occur over the next few years. Trillions of dollars of these securities have already been injected, like a virus, into the global financial system.

But how could Wall Street titans collapse like a house of cards?

For Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac and Bear Stearns, the losses represented by these toxic securities simply overwhelmed their reserves and brought them down. And more are likely to fall once their books are corrected to reflect their actual holdings.

Many others will join them as other speculative operations such as credit cards and different varieties of risk insurance seize up. The American International Group (AIG) was felled by its massive exposure in the unregulated area of credit default swaps, derivatives that make it possible for investors to bet on the possibility that companies will default on repaying loans. According to Soros, such bets on credit defaults now make up a $45 trillion market that is entirely unregulated. It amounts to more than five times the total of the US Government bond market. The huge size of the assets that could go bad if AIG collapsed made Washington change its mind and intervene after it let Lehman Brothers collapse.

What’s going to happen now?

There will be more bankruptcies and government takeovers. Wall Street’s collapse will deepen and prolong the US recession. This recession will translate into an Asian recession. After all, China’s main foreign market is the US, and China in turn imports raw materials and intermediate goods that it uses for its US exports from Japan, Korea, and Southeast Asia. Globalization has made ‘decoupling’ impossible. We are like prisoners bound together in a chain-gang.

In a nutshell…?

The Wall Street meltdown is not only due to greed and to the lack of government regulation of a hyperactive sector. This collapse stems ultimately from the crisis of overproduction that has plagued global capitalism since the mid-1970s.

The key questions now are: How deep and long will this recession be? Does the US economy need another speculative bubble to drag itself out of this recession? And if it does, where will the next bubble form?

Walden Bello is President of Freedom from Debt Coalition, Senior Analyst at Focus on the Global South and Professor of Sociology at the University of the Philippines.

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