[R-G] [BillTottenWeblog] A Primer on the Wall Street meltdown

[Bill Totten]

The Wall Street meltdown is not only due to greed and to the lack of
government regulation of a hyperactive sector. It stems from the crisis
of overproduction that has plagued global capitalism since the
mid-seventies.

by Walden Bello

Focus on the Global South (September 25 2008)


Many on Wall Street are still digesting the momentous events of the last
ten days:

* One to three trillion dollars worth of financial assets wiped out.

* 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 US government now runs the world's biggest insurance
company.

* The biggest bailout since the Great Depression, with $700 billion,
being desperately put together to save the global financial system.

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 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.

The $700 billion buyout of banks' bad mortgaged-backed securities is not
a strategy but mainly a desperate effort to shore up confidence in the
system, to prevent the erosion of trust in the banks and other financial
institutions and preventing a massive bank run such as the one that
triggered the Great Depression of 1929.

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.

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.

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 financial system 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 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) redistribute 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, 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 1960s 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 forty to fifty 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 one index, 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.

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 in 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 scores of financial crises since capital markets were
deregulated and liberalized in the 1980s.

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 Department;

* 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;

* 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 one 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
that flooded the US in the last decade. Big ticket mortgages were
aggressively sold 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.

When the interest rates were raised on the subprime loans, adjustable
mortgage and other housing loans, the game was up. There are about six
million subprime mortgages outstanding, forty 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,
the value of which run into trillions of dollars, have already been
injected like a virus, into the global financial system. Global
capitalism's gigantic circulatory system was fatally infected.

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?
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.

_____

Walden Bello, a fellow of the Transnational Institute, is professor of
sociology at the University of the Philippines, president of the Freedom
from Debt Coalition and senior analyst at Focus on the Global South.

http://www.tni.org/detail_page.phtml?act_id=18716

_____

Comment from Tony B:

Bello is mostly on here, though his accounting of the 1997 Asian
financial crisis may need some revision, i.e. There is substantial
evidence that the 'crisis' was a purely US state-manufactured one: The
Clinton Administration was demanding that Thailand and Indonesia fully
open their financial markets to US finance and capital sectors. When
they objected, Clinton's Commerce Secretary, Robert Rubin, instructed
America's giant hedge funds to launch a speculative attack on the Thai
baht. The devastation then spread to Indonesia and then South Korea.
Lesson learned.

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