World Economy: The October crisis

Global economic downturn gaining momentum

The imminent October meltdown of the global banking system appears to have been averted, at least for the time being. But the credit crunch continues and capitalist leaders are forced to recognise the world is plunging into a deep recession. For many millions of workers this crisis in the profit system means unemployment, slashed incomes and untold suffering.

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The October crisis

After 15 September, with the bankruptcy of the big investment bank, Lehman Brothers, the deepening crisis in the global financial system entered a new, more acute stage. A group of major banks discussed a rescue of Lehman, but they were not prepared to step in without financial backing from the US government. The refusal of the treasury secretary, Hank Paulson, to underwrite a bail-out proved to be a catastrophic mistake. Paulson, Ben Bernanke and company intended to draw a line: no more government-financed bail-outs. Instead, the collapse of Lehman (and the simultaneous takeover of Merrill Lynch by the Bank of America) triggered a much wider crisis. In particular, it spread the crisis from the US to Europe.

Banks and big investors feared that Lehman’s losses would result in massive losses for other finance houses, especially through claims on credit default swaps used to insure Lehman’s borrowing. One of the first casualties was a money-market fund, which faced a liquidity/solvency crisis as a result of Lehman losses.

Money-market funds are a key element of the interbank lending system, the wholesale credit market normally used by banks for low-interest, secure funds to finance their day-to-day operations. The bankruptcy of Lehman and the takeover of Merrill Lynch provoked fears that ‘no bank or finance house was safe’, and this brought about a cardiac arrest of the interbank lending system.

The credit crunch had now become a total seizure of the banking system. The whole superstructure of securitised credit which, it was claimed, would provide abundant, cheap credit and virtually abolish risk, had collapsed. Commentators noted that this was the worst banking crisis since the outbreak of the first world war in 1914.

Once again, the US Federal Reserve and other central banks had to pump huge amounts of liquidity into the banks, taking in an ever widening circle of financial institutions and accepting more and more risky collateral.

Within a couple of weeks, the US, British and European governments were forced to implement the biggest bank-rescue package in the history of capitalism. In late September to early October, there were convulsions on world stock exchanges, which had previously been volatile and steadily declining. Unlike many previous crises, the stock-exchange falls have followed the banking crisis, rather than preceding it.

Shares fell precipitously in response to a series of events. Undoubtedly, big-business investors feared a systemic meltdown of the banking and financial system. Shares in oil companies and mining corporations, which have featured prominently in share indexes in recent years, plummeted as oil and commodity prices rapidly declined. There was also worldwide panic selling when the US House of Representatives rejected (29 September) the $700 billion bank-rescue package proposed by Paulson. This reflected a combination of free-market ideological opposition to a state bail-out of the banks and massive public anger at the handouts to bankers seen as responsible for the crisis. Later (3 October), a revised bail-out plan – already passed by the Senate – was passed by the House, reflecting pressure from business to ease the credit crunch and avoid a deep slump. Among workers and middle-class people, fury at the greed of reckless bankers was tempered by fear of economic collapse and mass unemployment.

At the same time, the fall on the stock exchanges reflected recognition that the world economy was already well on the way to a deep recession. ‘Global Dive by Markets on Fears of Long Slump’, reported the Evening Standard [London], on October 22. According to Morgan Stanley’s Global Share Index, there has been a 45% fall on major stock exchanges since the November 2007 peak. And the financial carnage is far from over.

Coordinated action by central banks

Events on 8 October and the following days marked the end of the ultra-free-market era opened by the Thatcher-Reagan deregulation measures of the early 1980s. The Brown government announced a £400 billion rescue plan to stabilise financial markets. The package includes measures to improve the liquidity and solvency of the banks, as well as guaranteeing interbank loans. The government announced it would invest up to £50 billion in banks, by taking preference shares – effectively, partial nationalisation. Within a few days, the government had invested a total of £37 billion in a majority shareholding of the Royal Bank of Scotland and a 40% share of the recently merged Lloyds-HBOS. At the same time, the government’s package added another £100 billion to the existing Bank of England short-term loan scheme, and also guarantees up to £250 billion of new bank debt, thus effectively guaranteeing interbank lending.

On the same day, the Federal Reserve, Bank of England, European Central Bank (ECB), and three other central banks announced a simultaneous 0.5% cut in lending rates. This is the first time there had been such a coordinated rate cut since the 11 September attacks in 2001. This interest rate cut marked a sharp about-turn for the ECB, which had previously refused to follow Fed and Bank of England cuts on the doctrinaire grounds that inflation was a greater danger than recession.

In the following few days, governments and central banks of the eurozone took similar measures to the British government, bailing out a series of banks with state funds and propping up the interbank lending system.

In the US (14 October) Paulson changed tack. The $700 billion package presented to Congress was primarily a measure to buy up the banks’ toxic mortgage-backed securities. Now, following the moves of Britain and the eurozone governments, Paulson used provisions inserted into the Emergency Economic Stabilisation Act to inject state funds into the US banking system. Paulson announced that he would put $250 billion of public funds into the system by buying shares in the participating banks. In reality, the US government pressured nine major banks to participate (they will receive about half the total funds), imposing only vaguely worded restrictions on executive pay. The rest of the money will be offered to regional and community banks. Earlier (7 October), the Federal Reserve had implemented plans to establish a special purpose vehicle to buy unlimited amounts of three-month commercial paper from banks and non-financial companies – effectively guaranteeing a key component of interbank lending.

These measures, following the nationalisation of the housing mortgage lenders, Fannie Mae and Freddie Mac, and the effective state takeover of AIG (the American Insurance Group), the US government now has a decisive hold over the banking sector.

Big business internationally faces an acute dilemma. Without state rescue, the global financial system would have collapsed, threatening a deep slump and the very survival of the capitalist system. At the same time, they fear the encroachment of the state into the sphere of private property and the pursuit of profit. Michael Glos, German economic minister, described the European bail-outs of banking insurance as “an indispensible exception” to general free-market policies.

The ‘indispensible exceptions’, however, are becoming more and more extensive. In Germany itself, the government was forced to bail out Hypo Real Estate. France, Belgium and Luxembourg bailed out the French-Belgian Dexia. Fortis was bailed out by the Belgian and Netherlands governments. In the case of Iceland, with the whole national economy being run as if it were a speculative hedge fund, the government was forced to nationalise the two biggest banks on the basis of a $4 billion loan from the Russian government.

Capitalist leaders are striving to downplay the implications of nationalisation or semi-nationalisation of significant sections of the banking and finance sector. It is only a temporary, emergency measure. Governments will not ‘interfere’ in the day-to-day running of banks (imposing minimal restrictions on directors’ pay and shareholders’ dividends). As soon as the crisis is over, state shares will be sold to private investors – quite likely at a profit!

But, having taken over key sectors of the banks (and guaranteeing their deposits and, in some cases, their debts), it will not be so easy for the state to withdraw. In fact, given the likelihood of a prolonged economic downturn, governments may be forced to intervene even more. Moreover, the idea that, in the next period, governments will make a profit on their bail-out operations is likely to prove to be a chimera.

Will it work?

Will the unprecedented interventionist measures taken by the US, British, European and other governments be enough to prevent a systemic collapse of the global banking system? For the moment (22 October), there appears to be a stabilisation. The premium on interbank lending (Libor, commercial paper, money-market funds, etc) has begun to come down, and interbank lending is slowly reviving. Nevertheless, the credit crunch continues and is likely to go on for a considerable time. Despite pressure from the governments that have pumped new capital into them, the banks are hoarding cash, reluctant to lend to any risky customers.

Referring to the US bank-rescue package, one senior banker said: “It doesn’t matter how much Hank Paulson gives us… no one is going to lend a nickel until the economy turns. Who are we going to lend money to? Only people who don’t need it”. (Andrew Sorkin, US Banks Keep Hold of the Cash, International Herald Tribune, 22 October) A financial analyst based in London made a similar comment about the European banks. “We expect rising loan defaults and further asset write-offs over the next couple of years to practically wipe out the governments’ capital injections, leaving banks at square one. Given that banks will need to increase their capital in order to expand their lending book, these measures on their own are unlikely to prevent bank lending from stagnating”.

Further defaults on loans, for instance, by shaky hedge funds or manufacturing corporations being hit by the downturn, could push more banks into bankruptcy, despite the recent government-funded recapitalisation. The existing shareholders of banks, moreover, are angry that the value of their shares has been diluted by governments being allocated preference shares in return for the capital injection. Many will spurn the rights issues (options for existing shareholders to buy additional shares) now being offered by many banks in attempts to boost their capital base. In the event of further insolvencies, governments may be forced to invest even more state funds, turning partial nationalisation into fully-fledged nationalisation.

There is no gratitude from the shareholders who enjoyed super-profits from the banks’ speculative activities over recent years. Their response to rescue by the state is: ‘Where will it end?’ In reality, even partial nationalisation shows the redundancy of private shareholders. If the governments have been forced to bail out the major banks, why should they not be run in the public interest, to meet the needs of society rather than pursue super-profits for a tiny, hyper-rich minority?

The emergency stabilisation of the banks, moreover, will not prevent a recession, now expected by most capitalist leaders and big-business investors to be deep and prolonged. The housing crisis, for instance, is far from over. The US housing bubble, which was at the root of the subprime banking crisis, continues to deflate. One in six US mortgages are now ‘troubled’ (either in arrears or default). Already $500 billion of subprime securities, arising from mortgage defaults, have been written off, and it is expected the total could rise to $1 trillion or $1.5 trillion. So far, in the US the fall in house prices together with the fall in the value of shares held individually in mutual funds or retirement account equity holdings have caused a wealth loss of $7 trillion. This has already resulted in a drop in consumer spending (down 1% in September over the previous year) and this is likely to become more severe.

At the same time, huge housing bubbles in Britain, Spain, Ireland and other countries have only partially deflated so far. As the downturn gains pace, with a rise in unemployment and a squeeze on workers’ incomes, there will be an increase in mortgage defaults, which will cause further problems for the banks and other financial institutions.

A number of hedge funds are reported to be in trouble. The US government has said it is not prepared to step in and rescue any of them. However, many hedge fund investors are withdrawing their investments from the funds, forcing the hedge funds to sell off assets. This is further pushing down the price of shares, etc. Moreover, the collapse of a major hedge fund, like Long Term Capital Management in 1998, could have a devastating effect on the finance sector. Paulson may yet be forced to eat his words on this question.

Recession in the real economy

’Ominous company news holds down stocks’, reports the International Herald Tribune (22 October). The downturn in the real economy – with a consequential decline in profits – is one of the main factors in the recent slump on stock exchanges. Even ‘blue-chip’ companies, like Caterpillar and DuPont, have recently reported reduced profits and warned of a bleak outlook for the global economy. The big car manufacturers, GM, Chrysler and Ford, have been making huge losses, and are being propped up by government-subsidised guarantees for their loans. Chrysler and GM bosses have even been discussing a merger, which will undoubtedly mean plant closures, massive job losses and wage cuts. One of the biggest investors in Ford, Kirk Kerkorian of Tracinda Investments, has recently sold his Ford shares – and others will no doubt follow his example.

The governor of the Bank of England, Mervyn King, finally recognised the obvious (21 October) when he said that a recession had begun. Even Gordon Brown, who foolishly claimed to have abolished ‘boom and bust’, has now been forced to accept that there is now a recession. Of course, he blames it on the ‘world economy’ rather than the performance of British capitalism or his own government’s enthusiastic support for neo-liberal policies. All the major economies have slowed to a virtual standstill, with the prospect of negative growth in the US, Britain, the eurozone, and Japan for several quarters, if not longer. Previous breakneck growth in China is also slowing.

Faced with this bleak prospect, Democratic leaders in the US Congress have called for a new stimulus package, a proposal which has been endorsed by Bernanke. “Now is not the time to worry about the deficit”, writes Paul Krugman, a pro-Obama New York Times columnist. He outlines a package for the US government, which could “provide extended benefits to the unemployed, which will both help distressed families cope and put money into the hands of people likely to spend it. It can provide emergency aid to state and local governments, so they aren’t forced into steep spending cuts that both degrade public services and destroy jobs. It can buy-up mortgages (but not at face value, as John McCain has proposed) and restructure the terms to help families stay in their homes. And it is also a good time to engage in some serious infrastructure spending, which the US badly needs in any case”. (Let’s Get Fiscal, International Herald Tribune, 18 October)

If Barak Obama wins and the Democrats strengthen their majority in Congress, it is very likely that a package on these lines will be adopted. Something similar has already been proposed by Nancy Pelosi, Democratic leader in the House of Representatives. Even before the new president takes over in January, it is likely that Democratic-controlled committees in Congress will propose some such package. Whether Bush would veto such a package remains to be seen.

Would a massive fiscal stimulus, probably on a bigger scale than the $150 billion implemented by Bush earlier this year (mainly tax rebates) have a major impact on the US economy? At best, it would limit the depth of the economic downturn. The example of Japan in the 1990s provides a comparison. After the collapse of the property bubble at the end of the 1980s, Japanese capitalism faced a deep and prolonged recession. The government introduced a series of massive stimulus packages, with government spending on infrastructure projects, etc. They probably prevented an even worse downturn, but did not revive the economy, which only just came out of stagnation in the last few years – before being hit by the current credit crunch.

In the US, moreover, Democrats frequently evoke the New Deal of the 1930s, which also involved massive government spending on infrastructure projects and welfare provision. However, New Deal spending failed to revive the US economy, which only began to grow again with the advent of the second world war, which created massive worldwide demand for US goods. In both the New Deal spending and the packages of the Japanese government in the 1990s, state spending was heavily biased towards the big corporations involved in the infrastructure projects. Both stimulus packages resulted in a massive escalation of state debt. The US national debt is already soaring because of the bank rescue plan. A further stimulus package will escalate it further and, although it may be delayed, it will sooner or later result in increased taxation (hitting the working class) and future cuts in state spending, especially on public services.

The scale and character of Keynesian-type stimulus packages in the US, Britain and elsewhere remain to be seen. Meanwhile, the global economic downturn is gaining momentum. A growing list of countries is queuing up for the intensive care ward, applying to the IMF for emergency loans: Pakistan, Hungary, Ukraine, Belarus and others. The International Labour Organisation estimates that the crisis will add 20 million to global unemployment, raising the total from 190 million in 2007 to 210 million by late 2009. But this is only a ‘provisional’ figure: “current projections could prove to be underestimates”.

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October 2008