by Norman Lowe
The deregulation, together with the spread of the latest computer technology, was certainly a ‘bold incentive and encouragement’ to the bankers who now had a free hand to indulge in all these types of speculation. It enabled the derivatives market to become global, and foreign-exchange dealing increased rapidly. In the two years leading up to the crash, there was a massive rush of money into derivatives and currency trading. The statistics are staggering: in 2007 the total value of the world’s stock market companies was $63 trillion; but the total value of derivative investments stood at $596 trillion – eight times the size of the real economy. It was as though there were two parallel economies – the real economy and a kind of phantom or fantasy economy which only existed on paper. Admittedly, not all the derivative dealings were speculative, but enough of them were risky to cause concern among perceptive financiers. As early as 2002 Warren Buffett, probably the world’s most successful investor, warned that derivatives were a time bomb, financial weapons of mass destruction, because in the last resort, neither banks nor governments knew how to control them. Paul Mason concludes that since the end of the 1990s, ‘this new global finance system has injected gross instability into the world economy’. By October 2008, even Alan Greenspan, a former chairman of the Federal Reserve, who had always claimed that banks could be trusted to regulate themselves, was forced to admit that he had been wrong. By the time the crisis peaked, some 360 banks had received capital from the US government.
2 Sub-prime mortgages and the collapse of the US housing market
The long-running housing boom in the USA reached a peak towards the end of 2005. House prices had been rising steadily and had reached levels that could not be sustained. Too many houses had been built, demand gradually fell and so did prices. The unfortunate thing was that many houses, especially during the latter stages of the boom, had been bought using sub-prime mortgages. These are mortgages lent to borrowers who have a high risk of being unable to keep up the payments, and for that reason sub-prime borrowers have to pay a higher interest rate. As house prices were rising, mortgage providers were able to repossess houses whose buyers defaulted on their mortgage payments, and make a profit from selling them on. When house prices began to fall, many lenders foolishly continued to push sub-prime mortgages, and suffered heavy losses when the buyers defaulted. The more careful mortgage providers took out insurance to underwrite their loans, so insurance companies like AIG, Freddie Mac and Fannie Mae were faced with huge payouts. Niall Ferguson, in one of his 2012 Reith Lectures, suggested that Freddie and Fannie should take a large slice of the blame for the crisis, because they encouraged people who really couldn’t afford to do so to take out mortgages.
Another of the practices that contributed to the meltdown was known as collateral debt obligation (CDOs). This was the packaging together of different debts and bonds for sale as assets; a package might include sub-prime mortgages, credit-card debts and any kind of debt, and anybody buying the package would hope to receive reasonable interest payments. In fact since the year 2000, buyers, which included investment banks, pension funds and building societies, had been receiving interest payments on average between 2 and 3 per cent higher than if the debts had not been bundled up. But then several things went wrong – houses prices fell by around 25 per cent, more people defaulted on the mortgage payments than had been expected, unemployment rose, and many people were unable to pay off their credit-card debts. One estimate put the likely losses to buyers at $3.1 trillion.
3 Leverage, short selling and short-termism
These were other tactics in which banks indulged in order to make money, and which eventually ended in disaster. Leverage is using borrowed money to increase your assets which can then be sold at a profit when the value increases. Lehman was guilty of this, having a very high leverage level of 44. This means that every $1 million owned by the bank had been stretched by borrowing so that they were able to buy assets valued at $44 million. In a time of inflation like the period 2003–6, these assets could be sold at a comfortable profit. But it was gamble, because only a small downward movement in the value of the assets would be enough to break the bank. As John Lanchester explains:
Lehman made gigantic investments in the property market, not just in the now notorious sub-prime mortgages, but also to a huge extent in commercial property. In effect, Fuld [Richard Fuld, head of Lehman Brothers] allowed his colleagues to bet the bank on the US property market. We all know what happened next.
As US house prices collapsed and the number of mortgage defaulters soared, Lehman was left with debts of $613 billion. In the words of Warren Buffett: ‘when the tide goes out it reveals those who are swimming naked’.
Short selling is a strange process in which the investor first borrows, for a fee, shares from a bank or other institution which is not planning to sell the shares itself. The investor then sells the shares in the hope that their price will fall. If and when this happens, he buys the shares back, returns them to the owner and keeps the difference. It is the company whose shares are being sold and bought that suffers, as illustrated by the plight of Morgan Stanley. As the crisis deepened investors began to move their money out. In three days 10 per cent of the cash on Morgan Stanley’s books was withdrawn. The share price began to fall and this was the signal for short sellers to unload their Morgan Stanley shares, sending the share price plunging further.
Short-termism is the common banking practice of lending money for long terms and borrowing it for short terms – you issue a long-term loan and fund it by short-term borrowing yourself. When lending between banks dried up in September 2008 following the rush of depositors to withdraw cash, many banks were unable to pay out. This was because they had lent too much out on long-term loans which they could not get back immediately, and had failed to keep to the rule that they must hold a large enough ‘cushion’ to fall back on. Many banks tried to get round this regulation by setting up a sort of ‘shadow’ banking system. Paul Mason explains how the system worked:
The essence of the shadow banking system is that it is designed to get round the need for any capital cushion at all. Almost everybody in the shadow system was ‘borrowing short’ by buying a piece of paper on the vast international money market, and then ‘lending long’ by selling a different piece of paper into that same money market. So it was basically just traditional banking: but they were doing it with no depositors, no shareholders and no capital cushion to fall back on. They were pure intermediaries. They did it by exploiting a loophole in the regulations to create two kinds of off-balance sheet companies known as ‘conduits’ and ‘structured investment vehicles’ (SIVs). … The conduits were set up by banks in offshore tax havens. The bank would, theoretically, be liable for any losses, but it did not have to show this on its annual accounts.
Incredible as it may seem, all this was kept secret from investors, which didn’t matter when all was running smoothly. But there was one huge flaw in the system: it could only work as long as bankers continued to buy and sell everything on offer. As soon as short-term credit was no longer available, bankers could not fund their long term loans, and inevitably some pieces of paper became unsaleable.
4 Regulators and credit-rating agencies failed to do their job satisfactorily
Since 2000, thanks to the actions of both the US and UK governments, regulation of the banking system had been exercised with what can only be described as a light touch. The politicians were apparently happy to continue this non-interventionist attitude since bankers had played an important part in achieving the consumer boom and full employment. They mistakenly believed that bankers could therefore be trusted not to do anything too risky. The credit-rating agencies were the second line of defence against high risk. The three main agencies are Standard and Poor’s, Moody’s and Fitch. Their job is to carry out a risk-assessment process on banks, companies and assets and award grades showing investors whether or not it would be safe to do business with them. The safest gets an AAA rating, while BB or
less indicates a high-risk institution or commodity. Between 2001 and 2007 the amount of money paid to the three main credit rating agencies doubled, reaching a total of $6 billion. Yet an official report published in July 2007 was highly critical of the work of the rating agencies. They were accused of being unable to show convincing evidence that their methods of assessment were reliable, especially in the case of CDOs. They were unable to cope with the vast increase in the amount of new business that they were called on to do since 2000. Many critics saw the whole system as suspect: the fact that institutions and sellers of bonds actually paid for their own ratings invited ‘collusion’; if they gave the correct ratings, they risked upsetting the banking business and losing market share. As a result, no decisive action was taken until it was too late. For example, it was only a matter of hours before the British HBOS collapsed in September 2008 that Standard and Poor’s downgraded it, and even then the comforting phrase, ‘but the outlook is stable’, was added.
(c) The aftermath of the crash
Although the capitalist financial system had been saved from total collapse, the consequences of the crisis were clearly going to be felt for a long time. As the money supply dried up, demand for goods fell, and across the world, manufacturing industry slumped. Many of the weakest companies went to the wall and unemployment rocketed. In the USA in the first few months of 2009 it was calculated that around half a million jobs a month were being lost. The great exporting nations like China, Japan, South Korea and Germany suffered huge falls in exports. Although central bank interest rates were almost zero in the USA and Britain, nobody was investing to try to stimulate the still declining economy. Attempts to deal with this problem included:
Fiscal stimulus provided by governments and central banks. As early as November 2009 the Chinese government had decided to supply cash worth $580 billion over the next two years to fund various environmental projects. Banks were encouraged to lend vast sums of money, guaranteed by the state, to fund other projects. Millions of new jobs were created, and within a few months China’s economic growth rate had recovered and surpassed its previous high point. The main problem was the uncertainty about how risky those massive bank loans were. In the USA, newly elected Democrat president Barack Obama’s fiscal stimulus of $787 billion went into operation in February 2009. It was a controversial move because the Republican party was totally against it; even in a crisis as serious as this, they believed that the state should not be expected to provide help. A right-wing Republican group calling themselves the Tea Party Movement launched an anti-stimulus protest campaign encouraging Republican state governors not to accept stimulus money. Although the US economy did begin to grow again towards the end of 2009 and continued slowly through 2010, there were still 15 million unemployed at the end of the year.
In the EU the effects of the crisis varied among its 27 member states. They experienced different degrees of recession, though the average growth reduction at the end of 2009 was 4.7 per cent. The three Baltic states fared the worst, suffering full-scale slump: Estonia’s GDP fell by 14 per cent, Lithuania’s by 15 per cent and Latvia’s by 18 per cent. France did best, losing only 3 per cent of GDP. Most states borrowed heavily in order to launch fiscal-stimulus packages. For example, in 2009 France’s borrowing was equivalent to 8 per cent of GDP and Britain’s was 11 per cent. These amounts were quite small compared with America’s and China’s, but in the case of France they were successful: as early as August 2009 the French economy was growing again. The problem was that they were all left with massive national debts. Those countries which had signed up to the Maastricht Agreement of 1991 (see Section 10.4(h)) had broken the rules that borrowing must not exceed 3 per cent of GDP and total debt must be limited to 60 per cent of GDP.
Quantitative easing (QE). This was the practice, first thought of by John Maynard Keynes back in the 1930s, of increasing the amounts of cash in circulation by ‘printing money’. In fact nowadays banks do not actually print new notes; the central banks simply invent or create more money which is added into their reserves, and then used to buy up government debts. The UK was the first to use QE in March 2009 when a modest £150 billion was ‘created’, and this to some extent helped to put demand back into the system. According to Paul Mason, ‘Britain’s “pure” QE strategy saw it inject around 12 per cent of GDP into the economy. The Bank of England estimates this should, over a period of three to four years, filter through into a 12 per cent increase in the money supply and thus in demand.’ The USA adopted QE soon after Britain. However, the European Central Bank rejected QE on the grounds that it would threaten the stability of the euro. It was argued that simply making more of the existing money available to eurozone banks and buying AAA-rated bonds would be sufficient to stimulate demand. But demand was not sufficiently stimulated and consequently the value of the euro was weakened. By the end of 2009 the eurozone was in big trouble as the cost of all the fiscal stimulus and bank bailouts had to be faced. Some economists were already predicting that the zone was on the verge of break-up. In fact some economists and politicians hoped it would break up, so this seemed an unmissable opportunity!
(d) The eurozone in crisis
The financial crisis in Greece sparked things off. In October 2009 the newly elected social-democrat government discovered that the country’s budget deficit – which stood at 6 per cent according to the previous government – was in reality 12.7 per cent. Over half its actual debt, with a little assistance from Goldman Sachs, had been moved into the shadow-banking system, ‘off balance sheet’. It later emerged that there were serious flaws in the Greek system that had allowed massive tax evasion and other corrupt practices, such as pensions still being paid to families of the deceased. The immediate problem was that Greece had financed its national debt with short-term loans, a quarter of which were due for repayment in 2010. How were they going to find the necessary €50 billion? The first step was to introduce strict austerity policies – cuts in pensions, wages and social services and a campaign to eliminate tax evasion. Eventually in May 2010 the eurozone banks and the IMF agreed a loan of €110 billion to Greece, provided they fulfilled the austerity programme. This was extremely unpopular with the Greeks, and resulted in strikes and two general elections over the next two years. By the autumn of 2011 there seemed a real danger that Greece would default on its debts. Worried about the disastrous effects this might have on other members of the eurozone, leaders agreed to write off half of Greece’s debts to private creditors.
Meanwhile some other eurozone countries had also got themselves too heavily in debt. In November 2011 the Republic of Ireland had to be helped with a bailout of €85 billion. Portugal, which had suffered crippling competition from Germany and China, was on the verge of bankruptcy. In July 2011 Moody’s had downgraded Portugal’s debt to ‘junk’ status, and in October it too received an IMF bailout. Portugal had the lowest GDP per capita in western Europe and in March 2012 the unemployment rate was around 15 per cent. By August 2011 Spain and Italy had drifted into the danger zone. Paul Mason explains what happened next (in Why It’s Kicking Off Everywhere: The New Global Revolutions (2012)):
The European Central Bank was forced to break its own rules and start buying up the debt of these two massive, unbailable economies. The dilemma throughout the euro crisis has been clear: whether to impose losses from south European bad debts onto north European taxpayers, or onto the bankers who had actually lent the money to these bankrupt countries in the first place. The outcome was always a function of the level of class struggle. By hitting the streets, Greek people were able to force Europe to impose losses on the bankers; where opposition remained within traditional boundaries – the one-day strike, the passive demo – it was the workers, youth and pensioners who took the pain. Meanwhile Europe itself was plunged into institutional crisis. Monetary union without fiscal union had failed.
27.8 THE WORLD ECONOMIES IN 2012
At the turn of the millennium ‘globalization’ had been the buzzwo
rd. It seemed to promise huge benefits for the world – increased connectivity between countries, faster growth, greater transfer of knowledge and wealth, and perhaps even a fairer distribution of wealth. Economists talked about the ‘BRIC’ countries, meaning Brazil, Russia, India and China. These were the world’s fastest growing and largest emerging market economies, and between them they contained almost half the world’s population. Many economists were predicting that it was only a matter of time before China became the largest economy in the world, probably some time between 2030 and 2050. Goldman Sachs believed that by 2020 all the BRIC countries would be in the world’s top 10 economies, and that by 2050 they would be the top four, with China in first place. The USA was expected to have been relegated to fifth place.
There were differing views about actual details of how this scenario would play out. In 2008 the BRIC countries held a summit conference. Many analysts got the impression that they had ulterior motives of turning their growing economic strength into some kind of political power. They could carve out the future economic order between themselves. China would continue to dominate world markets in manufactured goods, India would specialize in providing services, while Russia and Brazil would be the leading suppliers of raw materials. By working together in this way the BRIC states can present an effective challenge to the entrenched interests and systems of the West. However, the fact that these four countries have very little in common could mean that any economic and political cooperation would only be temporary, or rather artificial. Once China becomes the world’s largest economy, it might not need the other three. In that case it could be China and the USA that work together to lead the global economy.
