Afterthoughts : A Primer on the Wall Street Meltdown (update)

Oct 01

Flying into New York, I had the same feeling I had when I arrived in
Beirut two years ago, at the height of the Israeli bombing of that
city—that of entering a war zone.  The immigration agent, upon learning
I taught political economy, commented, “Well, I guess you folks will
now be revising all those textbooks?”  The bus driver welcomed
passengers with the words, “New York is still here, ladies and
gentlemen, but Wall Street has disappeared, like the Twin Towers.” 
Even the usually cheerful morning shows feel obligated to begin with
the bad news, with one host attributing the bleak events to “the
fatcats of Wall Street who turned into pigs.”

This city is shellshocked, and most people still have to digest the momentous events of the last two weeks:

-$2.3 trillion dollars of investor wealth went up in smoke last week as
the Dow Jones Industrial Average registered its worst week ever,
plunging 18 percent as investors panicked and kept on unloading stock
despite various US government plans to bail out the banks;

-The collapse of one of the Street’s most prominent investment banks,
Lehman Brothers, followed by the largest bank failure in US history,
that of Washington Mutual, the country’s largest savings and loan
institution;

-Wall Street effectively nationalized, with the Federal Reserve and the
Treasury Department making all the major strategic decisions in the
financial sector and, with the rescue of the American International
Group (AIG), the amazing fact that the US government now runs the
world’s biggest insurance company;

-Over $8.4 trillion in total market capitalization has been wiped out
since October of last year, with over a trillion of this accounted for
by the unraveling of Wall Street’s financial titans, and now banks are
beginning to totter in Europe as the “American financial virus” spreads.

The usual explanations no longer suffice.  Extraordinary events demand extraordinary explanations.  But first…

Is the worst over?

No, if anything is clear from the contradictory moves of the last
week—allowing Lehman Brothers and Washington Mutual to collapse while
taking over AIG, and engineering Bank of America’s takeover of Merrill
Lynch–there is no strategy to deal with the crisis, just tactical
responses, like the fire department’s response to a conflagration.
(Some say this description is an insult to the fire department.)

The moves of the US and European governments amount to desperate
efforts to shore up confidence in the system, to prevent the erosion of
trust in the banks and other financial institutions and prevent a
massive bank run such as the one that triggered the Great Depression of
1929.

The financial crisis has now spread to Europe and Asia, and it is no
longer something that only affects banks that hold subprime securities
they bought from US institutions.  It is now a question of fear
overcoming trust.  Banks don’t want to lend to corporations because
they want to hold on cash and other secure assets to defend themselves
from an unpredictable conflagration, and depositors have growing fears
about whether their money is safe in the bank.  In this crisis, no
bank, even the seemingly most impregnable, is safe from a run such as
that which triggered the Great Depression in 1929.  In a run, no bank
is solvent.

What caused the collapse of global capitalism’s nerve center?  Was it greed?
    
Good old fashioned greed played a part.  This is what Klaus Schwab, the
organizer of the World Economic Forum, the yearly global elite jamboree
in the Swiss Alps, meant when he told his clientele in Davos earlier
this year: “We have to pay for the sins of the past.”

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 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 multitrillion dollar
trade that brought down AIG.

On December 17, 2005, when International Financing Review (IFR)
announced its 2005 Annual Awards — one of the securities industry's
most prestigious awards programs—it had this to say: "[Lehman Brothers]
not only maintained its overall market presence, but also led the
charge into the preferred space by … developing new products and
tailoring transactions to fit borrowers' needs…Lehman Brothers is the
most innovative in the preferred space, just doing things you won't see
elsewhere."

No comment.  But Warren Buffett, a grand speculator who eliminated
derivatives from his investment fund long before the recent crisis,
called derivatives in 2003 “financial weapons of mass destruction”
devised by “madmen” whom he recently defined as “geeks bearing
formulas.”  The truth is that the top graduates of the US business
schools like Harvard and Stanford brought us this crisis.

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, not because
government was not capable of regulating but because the dominant
neoliberal, laissez-faire attitude prevented government from devising
effective mechanisms with which to regulate. The massive trading in
derivatives helped precipitate this crisis, and the man who did the
most to prevent the regulation of derivatives was Alan Greenspan, the
former chairman of the Federal Reserve Board, who believed that the
derivatives market would regulate itself.     

The US Congress agreed with Greenspan and passed a law excluding
derivatives from being regulated by the Securities Exchange Commission
in 2000.  Deregulation, it must be noted, was not just a Republican
initiative.  It was bipartisan.  Led by Wall Streeter Robert Rubin,
Bill Clinton’s Treasury Secretary, the Clinton administration and
Congressional Democrats were also strong supporters of another law that
helped father the current crisis, the repeal of the Glass-Steagall Act,
which prevented commercial banks from also being investment banks.  

But isn’t there something more that is happening? Something systemic?

Well, George Soros, who saw this coming, says what we are going through
is the crisis of the “gigantic circulatory system” of a “global
capitalist system that is…coming apart at the seams.”

To elaborate on the arch-speculator’s insight, what we are seeing is
the intensification of one of the central crises or contradictions of
global capitalism which is the crisis of overproduction, also known as
overaccumulation or overcapacity.  

This is the tendency for capitalism 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 period of rapid growth both in the center economies and in
the underdeveloped economies—one that was partly triggered by the
massive reconstruction of Europe and East Asia after the devastation of
the Second World War, and partly by the new socio-economic arrangements
that were 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?

Well, this period of high growth came to an end in the mid-seventies,
when the center economies were seized by stagflation, meaning the
coexistence of low growth with high inflation, which was not 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, while social inequalities within countries and
between countries globally limited the growth of purchasing power and
demand, thus eroding profitability. This was aggravated by the massive
oil price rises of the seventies.

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?

Neoliberal restructuring  took the form of Reaganism and Thatcherism in
the North and Structural Adjustment in the South.  The aim was to
invigorate capital accumulation, and this was to be done by 1) removing
state constraints on the growth, use, and flow of capital and wealth;
and 2) 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.

The problem with this formula was that in redistributing income to the
rich, you were gutting the incomes of the poor and middle classes, thus
restricting demand, while not necessarily inducing the rich to invest
more in production.  In fact, what they did was to channel a large part
of their redistributed wealth to speculation.

The truth is neoliberal restructuring, which was generalized in the
North and south during the eighties and nineties, had a poor record in
terms of growth: global growth averaged 1.1 per cent in the nineties
and 1.4 in the eighties, whereas it averaged 3.5 per cent in the 1960’s
and 2.4 per cent in the seventies, when state interventionist policies
were dominant.  Neoliberal restructuring could not shake off stagnation.

How was globalization a response to the crisis?

The second escape route global capital took to counter stagnation was
“extensive accumulation” or globalization, or the rapid integration of
semi-capitalist, non-capitalist, or precapitalist areas into the global
market economy.  Rosa Luxemburg, the famous German revolutionary
economist, saw this long ago as necessary to shore up the rate of
profit in the metropolitan economies.  How?  By gaining access to cheap
labor, by gaining new, albeit limited, markets, by gaining 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.

China is, of course, the most prominent case of a non-capitalist area to
be integrated into the global capitalist economy over the last 25 years.             

To counter their declining profits, a sizable number of the Fortune 500
corporations have moved a significant part of their operations to China
to take advantage of the so-called “China Price”—the cost advantage
deriving from China’s seemingly inexhaustible cheap labor. By the
middle of the first decade of the 21st century, roughly 40 t0 50 per
cent of the profits of US corporations were derived from their
operations and sales abroad, especially China.

Why didn’t globalization surmount the crisis?

The problem with this escape route from stagnation is that it
exacerbates the problem of overproduction because it adds to productive
capacity.  A tremendous amount of manufacturing capacity has been added
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 another index devised
by economist Philip O’Hara, the profit rate of the Fortune 500 went
from 7.15 in 1960-69 to 5.30 in 1980-90 to 2.29 in 1990-99 to 1.32 in
2000-2002. By the end of the 1990’s, with excess capacity in almost
every industry, the gap between productive capacity and sales was the
largest since the Great Depression.

What about financialization?

Given the limited gains in countering the depressive impact of
overproduction via neoliberal restructuring and globalization, the
third escape route became very critical for maintaining and raising
profitability: financialization.

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—that is the financial sector is
turning 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 does not tell us is that the disconnect between the
real and the financial economy is not accidental—that the financial
economy 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?

The problem with investing in financial sector operations is that it is
tantamount to squeezing value out of already created value.  It may
create profit, yes, but it does not create new value—only industry,
agricultural, trade, and services create new value.  Because profit is
not based on value that is created, investment operations become very
volatile and prices of stocks, bonds, and other forms of investment can
depart very radically from their real value—for instance, the stock of
Internet startups that keep on rising, driven mainly by upwardly
spiraling financial valuations, that then crash. Profits then depend on
taking advantage of upward price departures from the value of
commodities, then selling before reality enforces a “correction,” that
is a crash back to real values.  The radical rise of prices of an asset
far beyond real values is what is called the formation of a bubble.

Why is financialization so volatile?

Profitability being dependent on speculative coups, it is not
surprising that the finance sector lurches from one bubble to another,
or from one speculative mania to another.

Because it is driven by speculative mania, finance driven capitalism
has experienced about 100 financial crises since capital markets were
deregulated and liberalized in the 1980’s.

Prior to the current Wall Street meltdown, the most explosive of these
were the Mexican Financial Crisis of 1994-95, the Asian Financial
Crisis of 1997-1998, the Russian Financial Crisis of 1996, the Wall
Street Stock Market Collapse of 2001, and the Argentine Financial
Collapse of 2002.

Bill Clinton’s Treasury Secretary, Wall Streeter Robert Rubin,
predicted five years ago that “future financial crises are almost
surely inevitable and could be even more severe.”

How do bubbles form, grow, and burst?

Let’s first use the Asian Financial Crisis of 1997-98, as an example.     

– First, capital account and financial liberalization at the urging of the IMF and the US Treasury Dept.;
    
– Then, entry of foreign funds seeking quick and high returns, meaning they went to real estate and the stock market;

– Overinvestment, leading to fall in stock and real estate prices,
leading to panicky withdrawal of funds—in 1997, $100 billion left the
East Asian economies in a few weeks;

– Bailout of foreign speculators by the IMF;
    
– Collapse of the real economy—recession throughout East Asia in 1998;
    
Unfortunately, despite massive destabilization, efforts to impose both
national and global regulation of financial system were opposed on
ideological grounds.

Let’s go to the current bubble.  How did it form?

The current Wall Street collapse has its roots in the Technology Bubble
of the late 1990’s, when the price of the stocks of Internet startups
skyrocketed, then collapsed, resulting in the loss of $7 trillion worth
of assets and the recession of 2001-2002.

The loose money policies of the Fed under Alan Greenspan had encouraged
the Technology Bubble, and when it collapsed into a recession,
Greenspan, to try to counter a long recession, cut the prime rate to a
45-year-low of 1 per cent in June 2003 and kept it there for over a
year. This had the effect of encouraging another bubble—the real estate
bubble.

As early as 2002, progressive economists such as Dean Baker of the
Center for Economic Policy Research were warning about the real estate
bubble. However, as late as 2005, then Council of Economic Adviser
Chairman and now Federal Reserve Board Chairman Ben Bernanke 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 subprime crisis broke in the summer of
2007?

And how did it grow?

Let’s hear it from one key market player himself, 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.”

Looking at the process more closely, the subprime mortgage crisis was
not a case of supply outrunning real demand.  The “demand” was largely
fabricated by speculative mania on the part of developers and
financiers that wanted to make great profits from their access to
foreign money—lots of it from Asia–that flooded the US in the last
decade.   Big ticket mortgages or loans were aggressively made 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 subprime 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”
(CDO’s) by the mortgage originators working with different layers of
middlemen 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.  The idea was to make a sale quickly,
make a tidy profit, while foisting the risk on the suckers down the
line.

When the interest rates were raised on the subprime loans, adjustable
mortgages and other housing loans, the game was up. There are about six
million subprime mortgages outstanding, 40 percent 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 several years. But securities
whose value run into trillions of dollars have already been injected,
like virus, into the global financial system.  Global capitalism’s
gigantic circulatory system has been fatally infected. And, as with a
plague, we don’t know who and how many are fatally infected until they
keel over because the whole financial system has become so
non-transparent owing to lack of regulation.

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—since lots of these holdings are recorded “off
the balance sheet”– are corrected to reflect their actual holdings of
these assets.  

And 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. 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
mega-size of the assets that could go bad should AIG collapse was what
made Washington change its mind and salvage it after it let Lehman
Brothers collapse.

What’s going to happen now?

We can safely say then that there will be more bankruptcies and
government takeovers, with foreign banks and institutions joining their
US counterparts, that Wall Street’s collapse will deepen and prolong
the US recession, and that in Asia and elsewhere, a US recession will
translate into a recession, if not worse.  The reason for the last
point is that China’s main foreign market is the US and China in turn
imports raw materials and intermediate goods that it uses for its
exports to the US from Japan, Korea, and Southeast Asia.  Globalization
has made “decoupling” impossible.  The US, China, and East Asia are
like three 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. The Wall Street collapse
stems ultimately from the crisis of overproduction that has plagued
global capitalism since the mid-seventies.  

Financialization of investment activity has been one of the escape
routes from stagnation, the other two being neoliberal restructuring
and globalization. With neoliberal restructuring and globalization
providing limited relief, financialization became attractive as a
mechanism to shore up profitability. But financialization has proven to
be a dangerous road, leading to speculative bubbles that lead to the
temporary prosperity of a few but which ultimately end up in corporate
collapse and in recession in the real economy.  

The key questions now are: How deep and long will this recession be?
Will it tip over into a depression? 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?  Some people say the
military-industrial complex or the “disaster capitalism complex” that
Naomi Klein writes about is the next one, but that’s another story?

*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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