The Credit Crunch: A Prelude to Capitalism’s Second Great Depression?
With the collapse of banks and entire countries facing bankruptcy Raphie de Santos looks at just how bad the prospects are for capitalism.
There is no doubt about it. Capitalism is teetering on the edge of its second great depression. While a recession is defined as two successive quarters of negative growth in an economy – set by economists as all the goods and services that are produced domestically or the gross domestic product (GDP) - there is no formal definition for a depression. Here we will define a depression as a prolonged recession lasting more than two years of successive quarters of negative growth and resulting in a 10% shrinkage in GDP. How did capitalism get to the edge of the precipice? In this article we try answer that question.
First, we will shows that at the root of this crisis for the world’s economy and global finance lay a series of economic and financial policies that were used to deal with capitalism’s last great economic slump: the 1974/1975 recession. We will identify what lay behind this crisis and what policies were put forward by capitalism to solve it. We will show that these policies were later extended, modified and added to by mainly the governments’ of Clinton, Bush, Blair and Brown to pull capitalism out of a speculative bubble. We will show that the world’s central banks implemented monetary policies without understanding the complexity of the financial system and products that they had helped create and the impact of their policy changes on them
Next we will try to explain the dynamics of the current crisis. How it has interacted with the real economy and the global financial system and has created a beast that is eating up the capital of global finance. These losses are so great that the whole global financial system is frozen and is on the verge of bankruptcy.
Following this, we will look at the strategies that governments have come up with to fight the crisis. Many governments and commentators are reviving the memory of Keynesian economics with their crisis fighting policies. We will show how these policies did not work, contrary to popular myth, in the first place, what actually solved the first great depression and how Keynesian solutions are even more unlikely to succeed this time round given the dynamics of this financial crisis.
We will then examine the Marxist theories of economic crisis and see if they can explain the current crisis or if some new theory or modification of an existing theory is required to do so.
Next we will chart how capitalism is likely to evolve from this crisis and what solutions it will try to inflict on the working class and poor of the world to save itself. We will ask if there may be a further rise in fascism as a means to this end.
Finally we look at how the effects of the crisis will make the workers and poor of the world will fight back against capitalism’s offensive and how socialists could organise to help transform this great crisis of capitalism into an opportunity to create a new society based on cooperation, that is democratically run and sets out to meet the needs of people and not the needs of capital.
At The Root of This Crisis
At the root of this crisis lies:
- a bubble in housing prices;
- a liberal lending regime to everyone from the poorest in the rich north to whole countries;
- the deregulation of the financial system;
- the breaking down of the demarcation lines in finance and banking;
- the creation of new complex financial instruments that can multiply the exposure to the assets they are based on;
- independent carefree interest rate policies.
These factors evolved from solutions to the 1974/75 economic slump. This slump marked the first synchronised economic recession since the end of the second world war. The recession came about as profit rates started to decline due to more and more human labour (mental and manual) was replaced by automation. In addition there was an over accumulation of capitalist profits that could not be profitability invested. This led to a massive over production of goods and services which could not be sold.
Capitalism tried to solve the problem of declining profits by weakening the organisations of the working class, increasing productivity and moving its production base to South East Asia where the rate of exploitation was greater. The problem of the over accumulation of capital was to create new avenues for it. Some of this was done through the privatisation of state industries and housing. The deregulation of financial markets and institution allowed some of this excess capital to be invested in financial speculation. Finally, to solve the crisis of producing too many goods capitalism created an easy market for credit on the back of private home ownership and the deregulation of financial markets and institutions.
The governments of Clinton, Bush, Blair and Brown further extended these neo-liberal policies. Their central bankers made a major error at the turn of the millennium when they cut their central bank lending rates dramatically – US rates fell to 1% and UK rates fell to 3.5%,. They did this as the so called dot com bubble burst and the US economy went into recession. This created a major housing bubble and because of the liberal deregulated financial markets and institutions, a wave of credit related products were created on the back of these very low interest rates which helped feed back into the housing bubble.
The Dynamics of the Crisis
Having created a giant housing and credit bubble and a raft of products and strategies that sought to take advantage of the very low interest rate environment central bankers on both sides of the Atlantic then unknowingly burst it rapidly. Worried about growing inflation , the by product of so much credit and increased demand from China, and the housing bubble, central bankers started to raise interest rates in 2006/2007. They had no idea of the vast network of products that were linked to the US house market or the depth of poor peoples’ borrowings – the so called sub-prime market. Up to 20% of US lending is sub-prime and an incredible 60% of US mortgages are in some form of derivative security. These were repackaged around the world and sold to all sorts of banks, financial institutions and pension’s funds. The US central bankers did not realise how sensitive the sub-prime lenders were to rises in interest rates. These lenders soon started to default on payments and this helped, as well as the increase in interest rates, to bringing about a fall in house prices. Products based on these sub-prime mortgages fell in value and financial institutions who bought them started to have financial problems and suffered huge losses – Bear Sterns being a good example. Those other institutions that had borrowed short-term in the money markets and lent this money long term – Northern Rock and HBOS are good examples of this – ran into trouble as the cost of short-term borrowing rose. Nobody would lend to them either as they feared they may go bankrupt as a result of this failed business model.
The dynamic of a falling housing market has continued and now has gone beyond sub-prime loans to prime and even super-prime loans as these borrowers face the same problems as the very poorest borrowers did. The US housing market was worth over $12 trillion at its peak and 60% of this as we mentioned has been repacked as some form of derivative and sold round the world. Other types of loans such as credit cards and car loans have been repackaged this way and in other countries as well as the US most notably the UK. These are the toxic assets that have been talked about and they are becoming even more toxic.
The banks were first afraid to lend to other banks and financial institutions because these borrowers may be potential defaulters and go bankrupt. Now the lending banks are suffering such losses on these repackaged loans and something called credit default swaps (CDS) that they need their money to cover day to day losses and quarterly write downs of mortgage and loan based products.
This has caused a complete freezing of the credit markets to everyone form the individual right through to small businesses to large corporations and governments and countries. This drying up of credit has pushed the world into an economic recession as consumer demand dries up and capitalism is unable to function because it cannot service its day to day running without credit. Of course the recession feeds into lower house prices and this feeds into more bank losses and more tightening of credit and a deeper recession and so on.
On a recession companies go bankrupt and here is a further problem for the banks. They have sold insurance against companies going bankrupt called CDSs. The value of this insurance has risen in value and hit the daily cash reserves of the banks and now as companies start to go bankrupt then the banks have to make a full payout to those who have bough the insurance on the bankrupt company. Recent examples have been Lehmans and an Icelandic bank. Up to $60 trillion of CDS insurance has been sold and the losses to the global banking system could be in the region of $10 trillion if we have a long severe recession as seems likely. This of course further freezes up credit which deepens and prolongs the recession which leads to more bankruptcies which feeds into more bank losses and so on! It is literally a spiralling dynamic that will be very difficult to stop.
The interacting dynamic of recession, falling house prices and corporate bankruptcies is taking us to the edge of a great depression. It is a dynamic that governments don’t fully understand and will be sucked into with disastrous consequences.
Solutions to The Crisis
Governments and central banks, particularly outside the US, have been kept on the hop in trying to deal with the crisis. They have moved from one fire to another mainly throwing money at the banking and financial system as they tried to stop financial institutions going bankrupt or the hemorrhaging of their capital and cash.
Governments have literally thrown trillions of tax payers dollars putting these fires out – it was revealed that the US Federal Reserve (FED) have spent over $US2 trillion over the last few months under existing legislation onto top of the $US700 billion recently announced rescue plan.
Because of the dynamic of the financial system losses the FED have abandoned buying the toxic mortgage backed securities as they had spent so much on keeping financial companies from going under. They understand that they will need more money in the near future as the recession deepens and the financial system losses spiral further out of control. There in lies the seeds of another problem. Just as governments want to spend money on capital projects and giving tax cuts to try and boost demand they will have very little money left to do this as they spend so much money on the bailouts.
These bailout which lead to a huge borrowing requirements which will be difficult to meet because nobody wants to hold the assets of a weak economy as that country’s currency will also be weak. Recently the German government failed to sell all its issue of government bonds and Germany is perceived to have the best quality of state debt. Too much debt financing by governments issuing bonds will also lead to high long-term interest rates which will push up short term interest rates as well. There is the possibility that governments could go bankrupt themselves and have to be bailed out by the International Monetary Fund – global capitalism’s central bank. Of course lending of the scale needed to bring the world out of recession also fuels inflation.
The other Keynesian policies of cutting interest rates and giving tax rebates can limit the depth, length and onset of a recession but not avoid one. This is what happened this time round in the US and their policies delayed the recession starting by three months. The rest of the world was slow to follow such policies and using tax rebates and cutting interest rates will now lead to individuals hoarding money for those unexpected bills or as insurance against losing their income in the future or the future tax increases to pay for it all in the first place!.
All these policies do not deal with the two fundamental requirements for a recovery in the global economy: capitalists to invest in fresh new projects and individuals to increase their spending, leading to a need to increase the production of goods and services.
In the 1930s it was massive arms expenditure, which in itself is inflationary, and a second world war which destroyed huge amounts of capital, that created the conditions for the recovery of capitalism after 1945.
Marxists Theories of the Crisis
These broadly fall in to two camps. One camp thinks that too much profit is being produced and accumulated and this means finding fresh avenues of investment. However too many goods and services are produced and these end up being unsold leading to a crisis of an over-production of goods. The other camp believes that as workers are more and more exploited by increases in productivity that their real wages decrease and as a consequence their demand for goods and services falls. Capitalism has to do this because their rate of profit is declining as more and more of the human labour in the production process – physical and mental – is being replaced by automation. This tends to happen as capitalism’s boom cycle approaches its peak.
Accompanied by every boom particularly as the peak is being approached is speculation in credit and credit based investments. This has happened with every cycle. In this crisis governments and central banks laid the basis for a massive bubble in credit and speculation which was able to be leveraged several times by the use of complex financial instruments called derivatives. As the name suggests they are not actual physical assets but are derived from the performance of a physical assets or in some cases economic measures which only have a mathematical reality – such as inflation or interest rates.
Capitalism needed new avenues to put it’s over accumulating capital and financial speculation was one of them. It also kept demand up as a real wages fell by giving everyone from the poorest in society to the affluent middle classes unlimited access to credit.
Ultimately, it was the drying up of credit which led to a huge decrease in demand that is fuelling this slump and recession. As Marx emphasised on several occasions in Capital ‘the ultimate reason for all real crises always remain the poverty and restricted consumption of the masses, as opposed to the drive of capitalist production to develop the productive forces as though the absolute consuming power of society constituted their limit’.
But it is the complete paralysis of the financial system with its exposure to recession multiplied several times by the use of derivatives that could take the world into its second great depression. This financial crisis is unprecedented either in scope, depth and complexity in capitalism’s history.
A New State Capitalism
There is a debate emerging between the left and right wings of capitalism. The right want to let private companies go the wall and have some bank bailouts but under bankers control to keep the financial system afloat. This right wing view is represented by the Republican administration in the US and the German Christian democratic government in Germany and Cameron’s Tories. The left view is a move to state control of the financial system, tighter financial regulations and the taking over of troubled major private enterprises such as General Motors in the US. This wing of capitalism is represented by the Democratic Party in the US and Brown government in the UK. Salmond’s SNP is somewhere between theses two camps.
China is likely to emerge as a stronger capitalist power as although its economy is slowing rapidly and it may go into a light recession it has less exposure to credit or to house bubble related assets. It is keen to attract international investors and private equity firms and corporate financiers may pile their money into China. They see it as the best bet of a recovery amongst the capitalist economies after they have suffered heavy losses, and the banks that lent them the money, on their projects in the mature economies of the north.
We are unlikely to see an emergence of fascism as a capitalist tool as happened in the 1930s when it was used to break a highly organised and politically conscious working class. This has already happened with the big defeats of the working class in the northern hemisphere in the early 1980s. Capitalism too has moved its production base to Asia and other emerging countries where it has much higher rates of exploitation and a more compliant work force.
There will be many struggles world wide against capitalisms onslaught to restore profitability and save itself. Many of the struggles against factory closures, redundancies and increased productivity will be led by the emerging working class in Asia. In the rich north there will be resistance as well and the opportunity will arise to build a new combative working class rank and file current as the ineffectiveness of the unions and their leaders becomes evident to the broad mass of the population.
Socialists have the opportunity to help build such an alternative current in and outside the workers movement as well as engage in the defence of public services which will come under attack as governments’ finances become stretched with the bank and industry bailouts.
We can help generalise these struggles and question the legitimacy of capitalism, its solutions of common ownership under capitalist control. We can counter pose our vision of a society under common ownership and under common control for the common good. A rationally planned society which is democratically decided upon and meets the needs of people and not the needs of profit and can end world hunger and stop the destruction of our fragile planet.
These are exciting times indeed.
Raphie de Santos is a member of the SSP and a supporter of the Fourth International. He was the former head of Equity Derivatives Research and Strategy at Goldman Sachs International and an adviser on financial markets and derivatives to the Bank of England, London Stock Exchange, The London International Financial Futures and Options Markets and the Italian Ministry of Finance. He now works as an analyst in fund management.