America’s financial meltdown: lessons and prospects

The international debt crisis symbolised by the collapse of Lehman Brothers and the forced sale of Merrill Lynch exposes the failure of the world's financial architecture. Ann Pettifor, whose openDemocracy article predicted the crisis in 2003, explains and looks ahead.
(This article was first published on 16 September 2008)

http://www.opendemocracy.net/article/america-s-financial-meltdown-lessons-and-prospects

The collapse of Lehman Brothers and the forced sale of Merrill Lynch which took shape over the weekend of 13-14 September 2008 have confirmed the scale and gravity of the global financial crisis. The difficulties at the insurance company AIG are a glimpse that there is more to come. But the extent of the wreckage makes it ever more important to analyse correctly what has gone wrong. For just as a faulty medical diagnosis can harm the patient, so a flawed economic diagnosis can lead to wrong conclusions and bad solutions.

In this respect, orthodox economists continue to be part of the problem that Lehman Brothers and Merrill Lynch (and, before them, Northern Rock, Bear Stearns, and Fannie Mae and Freddie Mac) represent. For so long they turned a blind eye to the finance sector, to privatised credit-creation and its role in fuelling asset-bubbles. In so doing they revealed their inability to predict, understand or offer solutions to a consuming crisis.

This article looks at how such failures took hold in the context of the deregulated global financial system of the 2000s, and why the predicted collapse of this system begins in the United States.

The deregulated economy

The former chairman of the Federal Reserve in the United States, Alan Greenspan, has himself said that what is happening to Lehman Brothers and Merrill Lynch is a "once-in-a-century" event. Yet the way many orthodox economists characterise Greenspan's own role in the global "debtonation" of the post-9 August 2007 era reveals how far they remain trapped in the rituals of evasion (see "Debtonation: how globalisation dies", 15 August 2007).

The key argument these economists make here is that the current crisis has been caused by the low interest-rate monetary policy Greenspan presided over after 2001. This case permits a twofold diversion - for it pins the blame for the crisis on interest rates (not deregulation of credit-creation) and on central bankers (not the private-finance sector). The policy implications of this focus neatly avoid proposals for what is clearly and urgently required: re-regulation of the finance sector.

But the argument that makes interest-rates a fundamental cause of the crisis is wrong even in its own terms - not least as it can lead to a recommendation that higher interest-rates are a way out of the mess. The crisis facing banks and individuals - indeed whole economies - buried under mountains of debt and threatened by an intractable deflation makes this a truly deranged proposal.

The phenomenon of "deleveraging" as a way of managing these mountains of debt helps explain why. Deleveraging means paying off (or more accurately writing off) the crazy amounts borrowed on the back of tiny amounts of real money - say the $1 million borrowed (or leveraged) on the back of $1,000 of sound collateral; deleveraging that debt would entail paying off / writing off $999,000. The inevitable result in many cases is bankruptcy, part of a wider deflationary momentum in the economy.

Debtors of all kinds - official, corporate, individual - are already struggling to repay at the current high real rates of interest. That is the core element of the debt crisis (or "credit-crunch"). To prescribe higher interest-rates would turn crisis for many individuals, companies and banks into catastrophe.

Here, the context of Alan Greenspan's post-2001 role is relevant in understanding the global economy then and now. For his policy of lowering interest-rates was a reaction to the bursting of the dot.com-bubble - which, like the property-bubble which burst in 2007, was fuelled and inflated by easy, unregulated and privatised credit-creation. Moreover, these low interest-rates in the early years of the 21st century were more a function of the new global capital markets than of the powers of central bankers to set low rates.

The result of deregulation (i.e. "globalisation") in the 2000s was and is that capital can flow free and untrammelled around the world. The accompanying collapse of the Bretton Woods system (which contained mechanisms for curtailing the growth of imbalances between nations) meant also the growth of large balance-sheet contrasts (massive deficits in the United States and Britain, huge surpluses in China and Japan, for example). The countries in surplus - China most of all - exported their excess capital to the US.

This flood of capital lowered rates of interest in the US - to the chagrin of Alan Greenspan, who by this time was trying to raise rates. Greenspan could have done this by erecting barriers to the movement of capital - capital controls - thereby preventing China's surplus capital from having an impact on US interest-rates. Instead, he preferred to pretend that he was impotent in the face of a mysterious "conundrum".

An Alan Greenspan or any other central banker armed with controls over the movement of capital would be able to switch a key lever of the economy: the rate of interest. That is, not just the "policy rate" or the "official rate" (often known as the "bank rate") but all rates - safe and risky, short and long. Where central bankers abandon such controls, and delegate powers over interest-rates to private bankers, they are impotent in the face of capital movements that affect the yields on bonds, and therefore of interest-rates within their domains.

The sharecropper society

The momentous news of the collapse of Lehman Brothers and the sale of Merrill Lynch - part of the larger process unfolding since "debtonation day", 9 August 2007 - brings all the failings of the seven years that preceded it into even sharper focus.

In 2003, as part of a team at the new economics foundation, I edited a book intended to "shadow" the International Monetary Fund's "world economic outlook", which we believed was based on the delusions of orthodox economics (see The Real World Economic Outlook, Palgrave, 2003). An article in openDemocracy at that time - five years ago almost to the day - heralded the "provocative new research ... which argues that the ‘first world' is approaching a major debt crisis... The reckless financial policies of leading western powers in the last two decades make it likely that the next seismic debt crisis will be in America, not Argentina" (see "The coming first world debt crisis", 1 September 2003).

The book and article explained that the current, post-Bretton Woods international financial architecture ("globalisation") was so structured as to enable the United States to "hoover up" money from the rest of the world, and use these resources to live beyond its means. I wrote then: "It is this financial system which makes US financiers so confident that the rest of the world will continue to finance their nation's extravagant spending binge. In the words of David Goldman, head of debt research at Bank of America Securities: ‘America is at little risk for the foreseeable future, simply because the world's capital has nowhere else to go' (Wall Street Journal, 13 August 2003)".

The fall of Lehman Brothers is final confirmation that the world's capital does now have somewhere else to go. This event thus marks the beginning of the collapse of today's international financial architecture, which has rested on very shaky foundations since Richard Nixon's administration unilaterally dismantled the Bretton Woods system in 1971 and began to shape the new.

The reason why the Lehman Brothers collapse is historic is that this institution expected until a very late stage to be saved by the state-run Korea Development Bank (KDP). But Seoul looked at the books and had other ideas: on 9 September 2008 - to the astonishment of Lehman's shareholders and investors - this ever-so-reliable ally of Washington refused to fund a bail-out.

The fact that such sovereign wealth funds as the KDP are no longer willing to finance reckless US institutions is of itself of the greatest significance. It implies a lack of confidence in the solvency of US financial institutions, and indeed of the United States as a whole. This will lead to a fall in the dollar, which will have profound economic implications for the global economy, and for globalisation as a whole.

The billionaire investor Warren Buffett wrote a letter to shareholders in March 2005, in which he predicted that by 2015 the net ownership of the US by outsiders would amount to $11 trillion. "Americans ... would chafe at the idea of perpetually paying tribute to their creditors and owners abroad. A country that is now aspiring to an ‘ownership society' will not find happiness in - and I'll use hyperbole here for emphasis - a 'sharecropper's society'."

Buffett was and is right. The collapse of banks and investment funds, and of the international financial system - a consequence of the unpardonable folly of the powerful - is serious and dangerous enough. But what is even more to be feared is the emergence of a sharecropper society, angry at its downfall. Thus will America's problem become the world's.

What’s Behind the Financial Market Crisis?

The financial crisis is not over. Neither tax rebates nor low interest rates nor higher or lower exchange rates can do the job of reviving an economy that is burdened by debt loads that are too high. On the contrary: the policy measures that the US authorities have been applying will prolong the agony. Be prepared for the challenges of extended financial turmoil and economic stagnation.

Early this year, the US central bank decided to manage the debt crisis in the light-hearted belief that a few aggressive rate cuts would “unfreeze” the banking system. Yet as of the end of the third quarter of 2008, the arteries of the financial system are still cluttered, and the financial system has moved even closer to total collapse.

Those banks and brokerages that haven’t yet failed have been kept alive by emergency monetary transfusions from the US central bank. The Fed has cast away all restraints of economic rationality and is acting in a purely political way. The Board of Governors of the US Federal Reserve System is pursuing the goal of getting the financial system through the mess — at least until the end of the year, no matter how high the costs will be thereafter.The American central bank has adopted the financial equivalent of the military strategy of scorched earth. The economic philosophy of the current chairman of the US Federal Reserve System can be summarized in the slogan, “No depression under my rule!” He resembles a military leader who stubbornly declares, “No defeat under my rule!” the more the chance of victory is slipping away, and defeat can be denied no longer.

The current economic disaster is the result of the combination of negligence, hubris, and wrong economic theory. For decades, an economic and monetary policy has been practiced based on the illusion of, “It doesn’t matter.” At first it was, “Deficits don’t matter.” From that, the policy of “it doesn’t matter” got extended to money creation, the credit expansion, the stock-market bubble, and the housing boom. Now, we’re being told that buying financial junk by the central bank to beef up banks and brokerages also doesn’t matter.

As a byproduct of this mindless economic and monetary policy, financial market operators, too, have lost their heads. Trusting the official cheerleaders, investors hold on in the trenches until they will have lost their last shirt. Economic weakness is spreading around the globe. There is no new spurt of economic growth in sight. Yet many investors stay put because they have been conditioned to believe that government will bail them out.

The current financial crisis is not of a cyclical nature. The financial turmoil is the symptom of the structural imbalances in the real economy. Over decades, expansive monetary policy has gone hand in hand with implicit and explicit bailout guarantees, and this has distorted the process of capital allocation. Under such perverted conditions, those investors will win most who cast away the restraints of prudence. It is a game that can go on for a long time — up to the point when the irrationality has become systemic.

The behavior of the investment community reflects the incentive structure that has been put in place by the authorities. Investors have learnt to dance to the tunes of the pied pipers at high places. After all, the individual market player could see from those who were ahead of him in the abandonment of prudence how money is being made. In the wake of this, financial companies have become overextended and are now in need of deleveraging. Yet the core problem lies in the imbalances of the real economy.

In the Austrian theory of the business cycle, the distinction is made between the “primary” and “secondary” depression. The secondary depression is what catches the eye: the turmoil in the financial markets. Yet the underlying cause is the distortion of the economy’s capital structure: the primary depression.

The simple fact is that the US economy is burdened with a highly lopsided capital structure as the consequence of a wide discrepancy between consumption and production, which, in turn, is the result of monetary policy. Persistent trade imbalances are the symptoms of this discrepancy. This means for the US economy that lower interest rates and government incentives aimed at boosting consumption work as pure poison. Instead of more consumption, more savings, less consumption and fewer imports are needed.

The current financial crisis reflects that many debtors have reached their debt limit and that creditors are lowering that limit. From now on, business and consumers, governments and investors must work under the restraints of lowered debt ceilings.

Economic policy as it is currently practiced is in a fix: lower interest rates may temporarily help to alleviate the financial crisis, but they exacerbate the fundamentals that are the cause of the financial crisis. Equally, a lower dollar would make imports costlier for the United States, while a strong dollar comes with lower import prices. But while a low dollar would help to expand exports, a strong dollar impedes export growth. Therefore, the United States will have high trade deficits as long as the economy does not fall deeper into recession.

Without an adaptation that would increase savings, decrease consumption, and reduce imports, the US economy can only go on in the old fashion with ever more debt accumulation. But the limit of debt expansion has been reached. The financial crisis has reduced the willingness of domestic and foreign creditors to extend loans.

Foreign creditors are getting ready to reduce their holding of US debt in a more drastic way. The governmental takeover of the mortgage agencies Fannie Mae and Freddie Mac bailed out the monetary authorities of China, Japan, Russia, and other foreign countries that hold agency debt. As a result of the socialization of the so-called government-sponsored enterprises, the Treasury opened a window of opportunity for these countries to unload their US assets at subsidized prices, all at the cost of the US taxpayer.

A profound restructuring of global capital has become unavoidable. Such a process is quite different from a recession in the traditional sense. In contrast to a sharp and typically short-lived recession, when, after the rupture, business as usual can go on, the restructuring of a distorted capital structure will require time to play out. Rebalancing the distorted capital structure of an economy requires enduring nitty-gritty entrepreneurial piecemeal work. This can only be done under the guidance of the discovery process of competition, as it is inherent in the workings of the price system of the unhampered market.

Anticyclical fiscal and monetary policies are of no help when it comes to the daily toil in business to work towards reestablishing a balanced capital structure. The so-called income multiplier won’t work, and lower interest rates won’t stimulate spending. On the contrary: these policy measures only make the task of the entrepreneur harder.

The difficulties ahead arise from the problem that business as usual cannot go on under conditions of a credit crunch, which has its roots in the distortions of the economy’s capital structure. Thus, even if the financial market turmoil were to settle, there won’t be the simple resumption of the old ways of doing business. The belief that, after the financial crisis is over, the real economy can reemerge unscathed, is probably the greatest error that many investors share with the policymakers.

As a result of the bailouts and the socialization of the mortgage agencies, the financial system is now fully infected with moral hazard. The disastrous effects of these government interventions will show up soon. The major task of bringing the capital structure in order is still ahead and more pain is in the waiting.As long as governments and central banks continue to focus on the monetary symptoms of the “secondary depression” and continue to ignore the structural aspects of the “primary depression,” they act like quacks. Ignorant of the lessons of the Austrian School, the authorities will most likely continue with their disastrous policies.

From http://www.prisonplanet.com/whats-behind-the-financial-market-crisis.html

Lessons of US financial crisis

Developments over the past fortnight are proving that the financial troubles originally brought on by the United States' sub-prime housing loan crisis, are worse than all but the most pessimistic were predicting when it first began making headlines about 18 months ago.

Last week Washington outlaid a huge expenditure for bailing out government-sponsored mortgage lenders Fannie Mae and Freddie Mac. Monday's tumble of the New York Stock Exchange of over 500 points on the heels of news that one of America's largest investment banks - Lehman Brothers - was declaring bankruptcy, and another, Merrill Lynch, was being sold to Bank of America, made it the worst day since Sept 16, 2001, the first day the NYSE opened for business after the World Trade Center attacks. All in all, it was estimated that about $700 billion in real value had been lost by market investors. The losses continued into yesterday, when the Federal Reserve Board was scheduled to meet to discuss strategies to staunch the bleeding.

Certainly in this age of globalisation the damage will not be confined to the United States. Trading yesterday was sharply down in all Asian financial market.

Former head of the US Federal Reserve, Alan Greenspan, said on Sunday that the US was now in a "once-in-a century" financial crisis, the worst he had seen in his career, and likely still had a long way to go. Eighteen months ago, Mr Greenspan was predicting that the US economy would weather the storm without a major fallout.

The US government has been playing with interest rates and applying tax revenues judiciously to try to avoid what many are now admitting is a real danger of financial collapse. What is most discouraging is that in these 18 months there has been very little done to address the real cause of this mess - the deregulation or lack of regulation of new sectors of the banking industry.

The term "sub-prime" literally means less than optimal, but many of the practices embraced by mortgage loan firms were just plain irresponsible. These included "balloon mortgages", where the borrower pays only interest on the loan for 10 years, at which time an accumulated payment comes due; and "liar loans", where the borrower is not required to submit documentation to verify reported income; and other devices to qualify just about anyone and everyone for a home mortgage loan.

These lending practices played a large role in the US housing industry boom, now just a memory, and played a large role in keeping the US economy in a growth phase. As more and more people came to the end of their "grace periods", the predictable wave of defaults and foreclosures gathered strength and took their toll on the economies of the US and the world.

Economist and New York Times columnist Paul Krugman was one of the first to sound the alarm about the situation. And in a column printed in the NYT on Monday, he warned about what has been described as a shadow banking system that goes far beyond just the housing mortgage sector and which has escaped the scrutiny of the federal government.

One reason for the lack of regulation is that few lawmakers have the sort of understanding Mr Krugman does for the very complicated issues involved. Another is that historically - as in Enron, the 1980s Savings and Loan scandal, etc - those who make their fortunes by playing loose with the rules are rarely the ones to bear the brunt of the economic hard times that follow.
Courtesy: bangkokpost

Who or what caused this financial crisis?

Investors and readers are no doubt aware of the benefits of the free enterprise system as practiced in the United States: entrepreneurship, innovation, ingenuity, dynamism, risk taking, wealth building, and commerce are chief among these benefits.

But readers also know that corporate capitalism has its drawbacks, including (but not exclusively) financial crises that have resulted in devastating economic and social upheavals.

1893, 1929, 1987, 20??

Moreover, despite technological change, productivity increases, and massive increases in wealth, it's remarkable how similar both the crises and the public policy responses have been over the hundred-plus year period: excesses occur, bad debts mount, some regulatory changes are implemented by the U.S. Government (and sometimes by state governments), and then corporate capitalism resumes.

Further, whether it's due to America's culture, its vast natural resources, something innate in Americans, human nature in general, or some other factor, or a combination, every time a crisis occurs, the American people, by and large, reach the same conclusion regarding what caused the crisis or problem: bad decisions or incorrect decisions. Basically, that people, mainly executives and other business leaders (sometimes federal/state regulators), made mistakes or bad decisions.

But we're in the globalization era now, with a myriad of changes, hence there's no guarantee that the changes the American people favored, say, 20 years or 80 years ago, will be the changes they support now.

In the months and quarters ahead, federal officials, and others, will be weighing a series of reforms, but keep in mind they're not likely to implement changes the public does not support, so it makes sense to find out what investors and readers think.

In your view, what caused the current financial crisis? Was it:

a) Bad decisions/mistakes
b) Bad/incompetent executives
c) Flawed economic system -- the economic system needs to be fixed.
d) A combination
e) None of the above/something else.
Courtesy: http://www.bloggingstocks.com/2008/09/18/who-or-what-caused-this-financial-crisis/