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Credit crunch threatens global downturn
The collapse of the sub-prime mortgage business in the US, brought home by the collapse of two hedge funds managed by Bear Stearns investment bank, provoked panic on money markets. The effects have already spread much wider than the housing finance sector. As a result, there is a paralysis of inter-bank lending and a seizing up of big sections of the wholesale money market.
This crisis is potentially much more serious than the Asian currency crisis of 1997 and its aftermath, the collapse of the Russian rouble and the bankruptcy of the hedge fund, Long Term Capital Management. At that time, the US and other advanced capitalist countries were in a relatively strong position and intervened to stabilise the world economy. The present liquidity crisis originates in the US, the product of a partial deflation of the housing bubble and other debt bubbles which developed after 2001. The global financial system is under threat.
Massive intervention by the US Federal Reserve, the European Central Bank and, belatedly, the Bank of England, as well as other central banks, may have averted a meltdown for the time being. But the frenzied financial speculation of the last few years has produced multiple bubbles which still pose a danger to the system. Moreover, there are already signs that the liquidity crisis, brought on by the slump in the US housing market, is in turn spilling over into the real economy. Capitalist commentators who in July dismissed the sub-prime crisis as a mere hiccup which would have a limited effect on the real economy are now gloomily contemplating a recession in the US and globally, with the possibility of an even more serious downturn in the world economy.
This is a turning point for the world capitalist economy. To avert the possibility of a serious downturn after the collapse of the dotcom bubble in 2001 and the potential impact of the 9/11 attacks, the Federal Reserve, followed by other central banks, slashed interest rates to near zero levels and opened the floodgates of global liquidity. This fuelled a series of bubbles – in housing, shares, commodities, currencies, debt trading, etc – that sustained world growth for several years. But underlying these bubbles is an unprecedented accumulation of debt, especially in the US, Britain, and other countries following the Anglo-US model. It is now becoming a dead weight on consumers, sections of business and governments. The sub-prime debt mountain has been the first to collapse, but others will undoubtedly follow.
The measures taken after 2001 only served to postpone a deeper crisis, as the current credit crunch shows. Moreover, the unprecedented imbalances between deficit countries, like the US and Britain which finance their consumption through debt, financed from abroad, and the surplus countries, like China, Japan and other South-East Asian countries, that have accumulated huge foreign currency reserves on the basis of their trade surplus, have grown even more extreme.
What expedient can capitalist leaders use now to avert a downturn in the world economy? Initially, as in 1997-98 and 2001, they have intervened to bail out floundering investment banks and cut interest rates. But given the enormous burden of debt already weighing on workers/consumers and sections of the capitalists themselves, it is by no means certain that more liquidity will do the trick. In the 1990s, for instance, Japanese capitalism suffered a decade of stagnation, with near zero growth, despite increasing state expenditure and pumping liquidity into the economy.
Financial globalisation has rebounded on the system. Capitalist leaders boasted that the near total integration of financial markets across the globe would provide lenders and borrowers everywhere with instant access to a completely liquid money market. Moreover, new types of financial securities, sophisticated derivatives, would spread the risk of borrowing so widely as to almost eliminate risk entirely. While economies were growing and bubbles inflating, it appeared that, through derivatives trading, any losses were widely diffused among speculators, apparently reducing risk to very low levels. Not even the most astute speculators or financial analysts could predict what would happen in the event of recession. The unanswerable question was: who would ultimately bear the risks arising from widespread defaults or bankruptcies? The veteran investor, Warren Buffet, warned that derivatives would prove to be ‘weapons of mass destruction’.
This fantasy of financial alchemy transforming high risk gambling into low risk money-making has now been shattered. Banks and other moneylenders knew that the sub-prime sector was risky. They pushed mortgages onto borrowers with insufficient incomes to repay huge loans on over-priced houses. Many loans, often for 80% or even 100% of the property price, were for 125 year terms. Borrowers were enticed with absurdly low interest rates (sometimes only 1%) – but which (read the small print) would shoot up to a high level after a year or even a month. Moneylenders and their agents made huge profits and fees.
The lenders, whether banks or specialised mortgage lenders, convinced themselves that they were eliminating the risk from this obviously risky business by selling off the mortgages through the money market, especially in the form of CDOs – collateralised debt obligations. Housing debt, in the form of bonds and other securities, was chopped and rebundled into packages containing securities of varying grades of risk, from investment grade to dodgy. The theory was that this diversification and diffusion of risky debt would reduce or even eliminate risk. The illusion developed that the CDOs were somehow less risky than the underlying debts.
As the US housing bubble peaked, however, and defaults began to escalate, especially among sub-prime borrowers, huge losses began to bankrupt major sub-prime lenders, as well as inflicting massive losses on hedge funds that had speculated in CDOs and other debt securities. The collapse of several big sub-prime lenders in the US made it impossible to trade CDOs and other derivatives linked to high risk mortgages.
Moreover, it soon became clear that the banks (both the big high street retail banks and investment banks) are, despite the derivatives market, still the lenders of last resort. Mortgage lenders still depend on banks to provide finance for their business, initially using bank funds to provide mortgages which are later sold on the money market. Hedge funds, too, rely on bank loans to finance their day-to-day trading in currency and money markets. Moreover, the banks themselves had, alongside their banking business, moved into the mortgage market through their own special investment vehicles – ‘off-balance sheet’ activity that has not been subject to government or central bank regulation.
In July and August, a number of US, British and European banks were hit by massive sub-prime losses, through both their borrower-clients and their own investment vehicles. They also fear further big losses, which cannot be calculated in advance. The banks therefore suspended most of their lending activities, fearing that prospective borrowers might be exposed to sub-prime losses.
Suddenly, moreover, banks would no longer lend to one another, even on an ‘overnight’ (24-hours) basis, the inter-bank lending that normally lubricates the financial system. The whole finance system was threatened with complete paralysis and could have melted down without the intervention of the central banks (especially the Federal Reserve and the European Central Bank).
The market in mortgage-linked securities is unlikely to revive in its previous form. Ironically, a big slice of lending has now returned to the banks, which had previously tried to offload it on to the open money market. In effect, there has been a forced return to ‘intermediated’ lending through the banks, reversing the recent trend towards ‘securitisation’, the parcelling of all kinds of assets into tradable investments (securities).
Globalisation, moreover, now ensures that any financial shock is immediately transmitted around global markets. This was shown by the crisis of the British mortgage lender, Northern Rock (see page seven). Its exposure to sub-prime loans was relatively low compared to some of the British banks. However, its chosen ‘business model’ was to finance 70% of its lending through securitising its loans on the open money market. When the market seized up in August, Northern Rock could no longer finance its business, and was forced to go to the Bank of England for credit.
That move triggered a classic run on the bank, with thousands of depositors queuing to withdraw their money – or using the internet to transfer their cash. Only a pledge from the government and the Bank of England prevented a draining away of Northern Rock’s capital, with a complete collapse. This could have resulted in runs on other banks using a similar ‘business model’. It became a political necessity for the Brown government to act to prevent a devastating loss of confidence, not only in the banks but in the government itself.
A US recession?
Will the credit-market crisis spill over into the real economy in the US and globally? Even if the liquidity crisis is contained, as it may be for a time, the US economy is now likely to go into a recession. In fact, the ongoing slump in the US housing market has already indicated growing problems in the wider economy. Despite the capitalists’ hopes for ‘decoupling’ – the continued growth of Europe, Japan, China and other regions through the development of their regional and domestic markets, and reduced dependence on the US – a US recession will most likely bring a global slowdown or worse.
The US housing bubble was a key factor in US growth since 2001. The ready availability of cheap mortgages fuelled a phenomenal house-buying spree. House prices on average (adjusting for inflation) were pushed up 70% more than consumer prices, and even more in some metropolitan ‘hotspots’. Many homeowners, including new buyers, used part of their mortgages to convert some of the increased value of their homes into additional purchasing power (in many cases trying to compensate for the real decline in household incomes over the last period). It is estimated that the bubble has created $8 trillion in housing bubble wealth. Now, the collapse of the bubble could cut annual consumer expenditure by between $160 and $540 billion.
The crisis in the risky, sub-prime sector is only the beginnings of a disastrous housing crisis, especially for lower income families who are being squeezed by higher interest rates, reduced incomes, and increasingly by rising unemployment. As housing prices generally fall, the crisis will spread to the ‘prime’ sector as well.
Alan Greenspan, former head of the Federal Reserve, has compared the situation to the savings and loans crisis of the 1980s. The rescue then cost the Federal government, ultimately the taxpayer, between $150-250 billion.
Until around the end of July, financiers and commentators were claiming that the decline in house prices would have only a minimal effect on the wider economy. US GDP growth for the second quarter of this year was 3.4%, significantly higher than the 0.6% of the first quarter. At the same time, however, consumer spending fell from 3.7% to 1.3% between the first and the second quarters, indicating the growing effects of the housing slump. Then, the August employment figures (issued in early September) showed an overall fall of 4,000, and this was accompanied by a downward revision of the June and July figures. The monthly average for new jobs created was only around 32,000, compared with 390,000 in the first quarter, a clear sign of a slowdown. This provoked a sharp dip in share prices in the US and elsewhere, aggravating already volatile stock markets.
Now there are widespread fears among capitalist leaders that there can be quite a severe recession. Consumer spending, which accounts for 70% of the US economy, will undoubtedly be severely squeezed as a result of the housing crisis. Moreover, serious breakdowns of other sectors of the financial markets cannot be ruled out, which means there can be further financial shocks which would impact on the real economy.
But the speculators are very optimistic. They are now placing their hopes for a continued growth of the world economy on ‘decoupling’. True, in the last few years, there has been an increase of intra-regional trade within Europe, Asia and other regions. The world economy, however, still revolves around the US-China axis. Japan and a number of European economies, for instance, have increased their exports to China and South-East Asia faster than to the US. This mainly reflects the increased supply of capital goods, production equipment, to China and other South-East Asian producers. But China and its neighbours are importing capital equipment in order to increase their output of manufactured goods – which they mainly sell to the US. A decline in US demand would work its way back through the Chinese economy, which would undoubtedly slow down, to China’s European and Japanese suppliers of production goods.
Many commentators argue that China and Japan could increase their domestic consumption, thereby sustaining growth. But western leaders have been calling on Japan for decades to stimulate domestic growth, but Japan, with its huge trade surplus, still depends decisively on exports. In China, the poverty level wages paid to most workers, and gross inequalities of wealth, strictly limit domestic purchasing power. This is a structural phenomenon which results from China’s economic relationship with the US and Europe, and will not be rapidly changed.
For these reasons, a recession in the US will lead to a slowdown in the rest of the world, and a more serious downturn in the US could lead to a worldwide recession, with minimal growth or even an absolute decline for a period.
Another factor is the role of the US dollar. This was previously significantly overvalued, as a result of capital flowing into the US. This was partly private capital in search of high profits, but also funds channelled by the governments of the surplus countries, particularly China, Japan and major oil producers, in order to sustain the US market which they rely on. The recent fall of the dollar, which has now been accelerated by the Federal Reserve’s interest rate cut, is likely to have a negative effect on world growth. US exports may increase as a weaker dollar will make US goods cheaper on world markets. But the rise of those exports will be limited by the slowing of major importers, particularly Europe and Japan.
As capital shifts from a slowing, debt-ridden US economy to Europe and Japan, the euro and yen will be pushed up in value, as we can already see. This will make eurozone and Japanese exports more expensive, cutting across the already weak growth of these major economies. At a certain point, moreover, there could be a massive flight of capital from the dollar, with a collapse in its value. Past experience shows that such a collapse would be likely to provoke a convulsion in the world financial system.
A weak dollar, reflecting a flight of capital from the US, will make it impossible for US capitalism to finance its annual trade deficits and accumulated capital debt on the scale of the last 15-20 years. That will mean a painful adjustment – a sharp cutback in consumption and living standards generally.
The US ruling class will undoubtedly attempt to offload the crisis onto its own working class, while pursuing aggressive trade and economic policies internationally in an effort to protect its national interests. It will also attempt to use its strategic power to safeguard its economic interests, enormously sharpening inter-capitalist rivalry and tensions internationally.
A turning point
There are, moreover, several other international factors which point towards increased difficulties for world capitalism, despite its record global growth during the last five years. The price of oil, for instance, has recently risen above $80 a barrel, which through higher fuel costs will cut consumption in all the major economies. In the event of a slowdown, the price of oil will undoubtedly fall again. But in the meanwhile it could help trigger a recession. World food prices have also risen sharply in the recent period, partly because of adverse weather and also because of increased demand for crops used for biofuels.
It is never possible to predict the exact course of the capitalist economy. There are too many factors involved, too many unknowns. Nevertheless, it is clear from recent events that the global economy has entered a new period of crisis. The debt-driven, multiple bubble economy of the last six years has begun to deflate. It is clear that the flood of liquidity, encouraged by the Federal Reserve and other central banks, only postponed the crisis that was developing at the time of the Asian currency crisis in 1997 and the collapse of the so-called dotcom boom in 2001. All the underlying contradictions remain, and the huge volume of global debt will increasingly become a dead weight on the global economy.
The expansion of credit – or the accumulation of debt – prolonged the post-2001 recovery cycle, even amazing the most optimistic capitalists. There has been record global economic growth of around 5% a year for five years. However, this has not led to generalised prosperity, even in the fastest growing economies. On the contrary, inequalities have grown, especially in countries like the US and China, and the huge imbalances between the deficit and surplus countries has become even greater. It is completely unsustainable and will at some point be corrected, quite likely provoking convulsions throughout world capitalism.
The big corporations have raked in record profits in recent years. But their capital expenditure, investment in new means of production, has fallen to historically low levels. Instead of investing, they have handed back money to their wealthy shareholders. This situation reflects the limitation of the market: the growth of consumer spending has been limited by the very inequality and poverty-level wages that have produced the record profits. Moreover, it is the lack of investment in production that has led to the grotesque expansion of the finance sector, with frenzied speculative activity – which mainly redistributes wealth within the circles of the super-rich.
Speculation, however, has clearly reached unsustainable levels. The collapse of the sub-prime mortgage market in the US, which still threatens the viability of many hedge funds and investment banks, is only the beginning. Institutions which have speculated in other fields, such as commodities, currencies, takeovers, public utilities, etc, may also face crises in the coming months.
Recently, there has been a huge growth of debt default derivatives, a means of lenders insuring themselves against borrowers defaulting on their loans. But what will happen when the scale of defaults escalates? As with any kind of insurance, a huge surge in claims can bankrupt the insurers, in this case, the institutions financing and trading the debt default derivatives market.
By pouring in massive liquidity, in effect, cheap, more or less unlimited credit for the big speculators, the central banks and major governments may avert a meltdown. But they will not be able to prevent a prolongation of the liquidity crisis, as more and more speculative institutions face losses or even collapse. The financial sector undoubtedly has the potential to produce further spasms which could have a devastating effect on the real economy. For instance, given the extent of financial globalisation, financial crises in the US or Europe can undermine apparently robust growth in Asia and other regions.
Whether or not a more serious crisis develops in the financial sector of the global economy, there will be a slowdown in the world economy. The only questions are how severe and how long?
Every economic crisis is also a political crisis for capitalism. As shown by the Northern Rock episode in Britain, the failure of banks and other financial institutions shakes public confidence, not only in financial institutions but also in the governments responsible for their regulation. In the next few years, the unfolding of economic crises will shatter the idea that capitalism is a ‘successful’ system, the only way of organising the economy and society.
This was recognised by Greenspan in his recently published memoirs, The Age of Turbulence. According to the Financial Times (17 September), “He endorses the view that stagnation in average worker incomes in the US poses a threat to the political sustainability of deregulated markets”. He also asks: “Why, for all capitalism’s material success, have we not been able to rediscover the 19th century optimism that free markets and free societies will bring a broader measure of human progress”.
When stagnation gives way to real cuts in workers’ living standards, there will undoubtedly be mass movements against the brutal effects of ‘deregulated markets’, in reality unfettered, ultra-free market capitalism. As in other regions of the world recently, there will be tremendous struggles against the effects of globalisation and neo-liberal policies. The capitalist system will be called into question, shaken to its roots, and there will be an intensified search among the advanced layers of workers for an alternative which, in our view, means a socialist planned economy and workers’ democracy.