World Economy : A crisis foretold

The Trillion Dollar Meltdown, By Charles R Morris

A crisis foretold

Angry shareholders at the annual meeting (27 May) of Société Générale denounced the management for turning the bank into a casino. SocGen was hit by a €50 billion ($79bn) loss as a result of the activities of the ‘rogue trader’, Jérôme Kerviel. To the shareholders, however, Kerviel was just a scapegoat – the product of the bank’s speculative activity.

The whole capitalist economy, especially in the US and Britain, more and more resembles a casino. The financial sector now accounts for around 50% of corporate profits. The shadow banking sector, composed of a handful of unregulated hedge funds and investment banks, now accounts for over half of all credit, while the traditional, retail banks are more and more embroiled in speculative activity through their unregulated, ‘off balance-sheet’ activity.

Credit has been the fastest growing sector of the world economy since the 1980s. In the early 1980s, total financial assets (stocks, bonds, loans, mortgages, etc), all claims on real things (property, companies, etc), were roughly equal to global gross domestic product (GDP). At the end of 2005, they were the equivalent of 3.7 times global GDP, in other words a claim not only on the current year’s output but on the best part of the next three years’ output. In the early 1980s, financial derivatives (claims on financial instruments) had only just begun to develop. By 2005, their total nominal value represented three times total financial assets and ten times global GDP. During the last three years, the financial sector has undoubtedly grown even bigger in relation to the real economy that produces goods and (non-financial) services.

Finance has been promoted in every way by government policy and legislation, with deregulation of financial-sector activities and favourable tax policy. Historically low interest rates (negative in real terms for over 31 months after 2000) provided the big gamblers with free money. Whenever there has been a threat of instability, Alan Greenspan and now Ben Bernanke have stepped in with further injections of liquidity.

The main activity of the investment banks and hedge funds is buying and selling debt between themselves (turning a profit on every transaction). This is undoubtedly a form of gambling, carried out at the expense of the great majority of society, that redistributes wealth from the majority to the rich – and from the rich to the super-rich. Between 1980 and 2005, the top tenth of taxpayers increased their share of taxable income from 34% to 44%. But the biggest gains were for the top tenth of 1% of the population, who increased their share of national cash income from 9% to 19%. The top one-hundredth of 1% (15,000 taxpayers) had an average income of $26 million after tax!

These trends are ably analysed in The Trillion Dollar Meltdown. Charles Morris is a former banker who has pursued a career in the US financial sector. He certainly knows how the system works and gives a clear and concise account of the financial infrastructure and its inner workings, as well as a snappy narrative of the development of the US economy over the last 25 years. If you want to know how CDOs (collateralised debt obligations), CDSs (credit default swaps), CMBSs (commercial mortgage-backed securities), and a host of other financial instruments work, this is the book to go to. Morris is not anti-capitalist, but his book serves as an excellent brief for an indictment of contemporary finance capitalism.

Morris saw the meltdown coming. His book went to press in November 2007, but anticipates the unfolding of the banking crisis continuing now. He understood that the creation of ‘risk free’ credit through a range of exotic financial instruments was a dangerous illusion. Sooner or later, the high risk loans – the ‘toxic waste’ concealed in various CDOs – would come back and hit the banks which had tried to pass on the debt through securitisation. Sure enough, from the time (June 2007) Bear Stearns was forced to wind up two of its hedge funds involved in the subprime mortgage market, the great unwinding began and still continues.

But the subprime crisis is only the beginning. Morris estimates total subprime losses of $450 billion – which many commentators now consider on the low side. But he estimates further potential losses of $345 billion from corporate debt, mainly from various kinds of high yield (junk) bonds and related financial instruments. In addition, there could be $215 billion losses from securitised credit card debt and CMBSs linked to commercial property development. All this adds up to the $1 trillion meltdown.

But it does not include any estimate for the potential losses from CDSs (credit default swaps), a form of derivative used to insure a range of other securities from default losses. These instruments only developed recently, but now total an incredible nominal value of $45 trillion. Morris regards CDSs as inherently risky (parties to the swaps, if they become insolvent, will be forced to renege on their deals), threatening colossal losses in the event of a meltdown in this sector. Defaults in the default swap market itself would lead to massive writedowns in the value of the securities previously insured by CDSs. “In short, we would be facing an utter thrombosis of the credit system that ‘could make the subprime mortgage problem look like a walk in the park’. There is no point even in attempting to estimate the scale of the losses”.

Even the prediction of a $1 trillion meltdown is a cautious estimate. It assumes an ‘orderly correction’ of financial markets. A convulsive, chaotic crisis – a disastrous collapse of the financial system – could produce losses of up to $3 trillion. This is similar to the estimate of potential financial losses put forward by Nouriel Roubini, dismissed by many commentators as absurdly high.

Clearly, a writing-off of losses between $1-2 trillion would mean a major financial crisis and an economic slump. Yet Morris also fears that the finance capitalists will attempt to conceal their losses as far as possible, postponing the write-off of worthless assets and avoiding a major sell-off that could lead to a slump of financial markets. This, says Morris, is what Japanese capitalism did when its own asset bubble imploded in the late 1980s: “A debacle… proportionately on the same scale as our current one, and [similar] in detail… Instead of addressing their problems, the tight network of incumbent politicians and bankers concealed them. And nearly 20 years later, Japan still has not recovered”.

Morris sees no easy way out, his scenario is for a hard landing, a combination of credit meltdown and economic recession. The US housing bubble, a major factor in the recent growth of the US economy, was itself produced by the flood of relatively easy credit, especially through subprime lending. The collapse of the housing boom has already begun to undermine consumer spending, the main driving force of US growth. US capitalism is sliding into recession.

There has already been a huge round of writedowns in the subprime mortgage sector, representing massive losses for the investment banks. However, there is little sign of an easing of the credit crunch. It is impossible to predict how far it will go. But Morris’s prediction at the end of last year may well be borne out: “The stage is set for a true shock and awe surge of asset writedowns through most of 2008. Widespread collateral defaults, particularly at the credit hedge funds, will trigger forced selling from margin accounts. Rolling downgrades will require divestitures by pension funds and insurance companies that find themselves in violation of rules on holding investment grade paper. Holders of senior CDO tranches will liquidate their holdings as credit protection dissolves, as they have the right to do. Add in even mildly bad outcomes from the monolines and in the credit insurance markets, and the global financial system will be in catastrophe”.

Analysing the present crisis, Morris says: “It amazes that we have come to such a place”. He ably describes the proximate causes: the flood of cheap credit, deregulation of financial markets, and developments in information and communications technology that facilitated the development of securitisation and global trading. But the ‘excesses’ of the bubble economy he simply attributes to the excessive swing of the pendulum from the pre-1980 liberal-Keynesian period to the free-market, monetarist consensus of the following period. But what were the economic and social forces underlying these trends?

Morris refers to the oscillation of the political/ideological cycle – from the Keynesian/liberal paradigm of the 1960s and 1970s to the Chicago-school brand of (ultra-free market) financial capitalism that developed from the early 1980s. There was undoubtedly an ideological/political shift of the ruling class. But Morris makes no attempt to root his explanation in an analysis of the changing balance of class forces and the dynamics of capitalist production.

The post-war upswing, according to Morris, faded away because of an excess of government intervention and regulation. He praises the policy adopted by the chairman of the Federal Reserve, Paul Volcker, who in 1980 squeezed inflation out of the system and initiated a period of positive (for a time, high) real interest rates. This favoured bankers and lending institutions. The changes of the Reagan era, including sweeping deregulation of finance (continued under Clinton), opened the way to the booming, ‘Goldilocks’ (not too hot, not too cold) US economy of the mid-1990s. However, Morris recognises that the reduction of consumer price inflation was accompanied by soaring asset price inflation. The capitalist class increasingly hoarded money and sought profit through financial speculation.

This development, however, reflected more than new technology and a change in government policy. The decline in productivity and profits at the end of the post-war upswing reflected the fact that capitalism, restricted by the private ownership of productive forces and the framework of the nation state, was reaching limits to its capacity to develop the productive forces. Increasingly, the capitalists turned away from productive activity to financial speculation. During the 1980s and 1990s, the capitalists have increased their profitability through intensified exploitation of the working class, while at the same time capital investment has fallen back to historically low levels. One of the features of the recent bubble has been the huge cash surpluses of many corporations, either siphoned off through pay and stock options by senior executives or handed back to shareholders in the form of dividends or share buy-backs. “Profits have been very high during most of the 2000s, and capital spending has been soft…” This excess, uninvested profit, is one of the main sources of the wall of money that has flowed into the financial sector. At the same time, the surpluses of major exporters like China, Japan and the oil exporting countries have also been channelled into the financial markets centred on the advanced capitalist countries.

Morris refers to “the extreme prominence of financial services in American economic growth” as the key factor in many of the developments he outlines. But it is the underlying organic crisis of capitalist accumulation which ultimately explains the development of the bubble economy and its grotesque excesses.

The “anti-regulatory zealotry” of the last 25 years has gone too far, Morris says. Like some other strategists of the ruling class in recent months, he has come to reject the idea that markets are always right, will resolve any problems. The subprime crisis (following on from a whole string of financial crises and scandals) is undermining the credibility of the US market system. Recent events may represent the “last gaspings of the raw-market Chicago-school brand of financial capitalism…” The restriction of the role of government, he says, has gone too far: “The domestic public sector in the United States has been impoverished and corrupted, and we’re paying a price for it… We will need to restore some balance. The very first priority will be to restore effective oversight over the finance industry”.

“My personal belief is that the 1980s shift from a government-centric style management towards a more markets-driven one was a critical factor in the American economic recovery in the 1980s and 1990s. But the breadth of the current financial crash suggests that we’ve reached the point where it is market dogmatism that has become the problem, rather than the solution. And after a quarter-century run, it’s time for the pendulum to swing in the other direction”.

Historical change, however, the transition from one period to another, does not proceed smoothly, like the swing of a pendulum. It is not simply a question of the capitalist class abandoning one ideological/political paradigm and adopting another. The strategists of capital really have no idea of how to find a way out. Capitalist governments may well turn back to the idea of regulation, but that will not fix the system, which is organically diseased. A major international crisis in capitalism will produce convulsive events and upheavals. And they will be faced with a mass revolt by the working class, poor farmers and the dispossessed who have been impoverished by the super-exploitation of finance-capital.

The Trillion Dollar Meltdown, By Charles R Morris

Published by PublicAffairs, 2008, £13.99 Sterling

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June 2008