Everywhere the cry is: credit crunch! You can smell the sweat on the brows of
bankers as their necks are squeezed by the tightening credit noose. In all the offices of the great investment
banks of Wall Street, the City of London and gnomes of Zurich, you can hear the
hissing sound of the global financial bubble bursting and deflating.
Whereas just a few months ago there seemed no end to upward
drive of stock market prices and availability of loans to buy companies, build
skyscrapers or invest in ever-mushrooming condominiums from San Diego to
Shoreditch and Shanghai; now all has changed.
An abyss has opened up before the financial sector of capitalism.
Every day another huge global bank announces that it has had
to ‘write-off’ the value of assets that it has bought (mortgage loans for
houses in the US or bonds that are ‘backed’ by the value of mortgages in
America). It’s $10bn for Citibank, $5bn
for HSBC, $8bn for Merrill Lynch and so on.
So far, the banks have fessed up to $60bn of losses.
And heads have rolled.
The head of Citibank, the biggest bank in the world (until a Chinese
bank surpassed it last month when it launched on the stock exchange), has been
sacked and forced into taking a redundancy package worth $150m. He was followed by the head of the biggest
investment bank in the world, Merrill Lynch.
And around the world, smaller banks and financial
institutions have not just lost money, but have gone bust. In the UK, it was Northern Rock, a lender of
mortgages in the north of England. Big
mortgage lenders have gone bust in the US.
The biggest American lender, Countrywide, is on the brink with huge
losses recorded. Desperately, the big
banks are trying to drum up a special fund worth $75bn to help fund lots of
small ‘Special Purpose Vehicles’ that they originally set up to make extra
profit.
Even supposedly ‘safe and prudent’ financial institutions
like company or local government pension funds have been burnt. Few people in the remote Norwegian town of
Narvik, 200km north of the Arctic Circle where the sun has disappeared until
January, were likely to have given a lot of thought to the credit squeeze
sweeping the global money markets – that is, until it threatens their wages
over Christmas.
Narvik, along with three other similarly isolated towns of
Hemnes, Rana and Hattfjelldal, has become the latest community to discover just
how directly even the most remote places can be affected by the financial
turmoil after it made multi-million dollar bets on complicated US-linked
financial products.
The towns invested about $96m (€65m) in complex products
linked to unspecified municipal bonds in the US, designed by Citigroup, and
sold to them by Terra Securities, the investment banking arm of one of Norway’s
leading banking groups. Now
representatives of the towns have admitted that recent market movements linked
to the credit crisis had destroyed most of the value of their investments.
The great credit crunch is not located just in the US, but
is everywhere. And it’s only just
begun. The OECD estimates that the
final losses from this credit contraction will be $300bn. Other bank estimates put the hit at
$400-500bn, or about 1% of global annual output.
It’s going to be that big because the start of the problem
was in the US housing market. Way back
in the early 2000s, a huge boom began in the US residential property market,
not dissimilar to the boom in the commercial (factories and offices) property
market that started in the mid-1980s in the US. As money flowed into the property market, mortgage rates
plummeted and banks began to offer easier and easier loan arrangements.
Whereas before the usual US mortgage for 75% of the value of
the house was at a fixed rate for 30 years, while house prices rose at a
moderate 3-5% a year, now you could get a 100% (or even more) mortgage at a
special discount rate of near zero for the first few years, with even the cost
of paying that ‘back ended’ to the cost of the loan, which could be just ten
years.
Moreover, if you could not prove that you had a good steady
job with income to pay the loan, it did not matter. Because house prices were now rising at 15% a year, you could
easily cover the cost by selling on or borrowing more later. Banks would lend what they called ‘sub-prime’
mortgages (so-called because they were made to riskier borrowers) without
compunction.
The housing boom took off as the Federal Reserve Bank cut
interest rates down to 1% and the head of the bank then, Alan Greenspan,
declared publicly that it was a great idea to borrow more and spend to keep the
US economy motoring. However, in June
2005, things began to turn for the worse.
First, rising inflation forced the Fed to reverse its policy and begin
to hike interest rates. It did so for
the next 18 months from 1% to 5.25%.
Mortgage rates rose sharply and borrowers began to feel the pinch.
Most important, house prices had got so far ahead of
incomes, which for the average American family had hardly moved, that lots of
new homes coming onto the market were no longer affordable. Builders found that they could not shift
their new condos without massive discounts and incentives. Eventually, even that was not enough and
those sub-prime borrowers who had bought without adequate incomes or had done
‘buy to lets’, with the hope of ‘flipping’ their purchases quickly into sales,
could no longer afford their homes.
Defaults on sub-prime mortgages rose from 3% to 15% in a
year. Lenders suddenly found that their
highly lucrative mortgage incomes were dropping fast. And here is where the problem got so much worse.
In the great new world of the global finance capital, the
mortgage lenders had not kept these mortgages on their books. They went to other banks and particularly to
smaller financial organisations like hedge funds (funded by blocks of capital
set up by some financiers using the money of very rich people and promising
them huge returns) and said: look why don’t you buy a block of mortgages from
us? Some mortgages will be prime (good
credit) mortgages and some will be sub-prime.
But a batch of this mortgage debt (a mortgage-backed asset) will pay a
lot more than interest at the bank or even interest from a government
bond. And don’t worry, it’s really safe
because house prices are going up and up and anyway your batch of mortgages
includes lots of good safe ones.
And then the banks went to insurance brokers and said: why
don’t you offer insurance on these mortgages defaulting? It’s not going to happen so you can make
money selling premiums to the buyers of our mortgage-backed securities. And they did.
Soon everybody and his dog was buying and selling mortgage
securities around the world. Sub-prime
mortgage securities reached $3trn globally and prime mortgages reached another
$25trn.
This was similar to what the savings and loans banks in the
US did in the 1980s. They were very
small savings banks that collected the savings of all the people in the small
towns of mid-America. Then they lent
their money to local businesses to build offices, factories and develop.
But a boom in commercial property broke out as interest
rates fell and the owners of these small banks thought they were onto a
winner. They began to lend to
businesses in a big way and got involved in lots of big commercial projects
offering very good low and fixed rates of interest. But then interest rates began to rise as inflation exploded in
the late 1980s. These banks found they
had to pay higher rates to depositors, but could not raise rates to their
business borrowers. The banks went
bust, or their owners did a runner with the local people’s deposits.
Both the savings and loans disaster in 1980s and the
sub-prime crisis now are examples of how a corrupt and greedy capitalism tries
to maintain economic momentum by turning to unproductive sectors because the
productive sectors have weakened.
In the US, the rate of profit earned by all sectors of
capitalist investment peaked in 1997 (see our previous articles in this
column). As explained by Marx,
capitalists are continually trying to increase the profit they make out of
their workers. If they don’t, then
their competitors will undercut them in price or invest more to lower
costs.
This competition drives capitalists to find new ways of
raising profits. Once they have exhausted
the exploitation of the workforce, they can only raise profit by using new
labour-saving forms of technology. That
requires extra capital invested in machinery and plant over labour. This rising proportion (that Marx called the
organic composition of capital) begins to drive the rate of profit down just as
the mass or overall total of profit rises.
Eventually, the falling rate of profit will exert enough influence to
stop the mass of profit rising.
That process began in earnest in 1997. Eventually the hi-tech boom of the 1990s
burst in a stock market collapse of 2000 and the mass of profit stopped rising
in 2001 and there was mild recession.
But the recession was only mild because capitalism tried to keep the
system going by the expansion of credit into unproductive areas like finance
and property. The boom in property
provided a cushion against the collapse of productive forces. This even reversed the fall in profitability
for a while, from 2002 to 2006.
Employment and economic growth also picked up.
But to achieve this, there had to be a huge expansion of
money credit, indeed the largest in capitalist history. Marx called this fictitious capital. Credit is money supply (printing banknotes
and increasing bank reserves), debt (issuance of bonds and loans) and stock
market values (increased prices for buying and selling shares in
companies). When this expands way
beyond the accumulation of real capital, it was fictitious. The prices of shares, bond and houses did
not match the value appropriated by capitalists from the sale of things and
services produced by workers in factories, offices and transport facilities,
namely profits.
In the first seven years of the decade of 2000, fictitious
capital grew at over 25% a year compared to the growth of real production in
the capitalist world (up a maximum of 5-7% a year). Money supply printed by the central banks rose about 7% a year,
while banks increased loans by over 10% a year. And then there was the issuance of bonds by big companies and
governments. That form of credit rose
by over 15% a year to reach $73trn by 2006, or around 140% of world annual
production.
But the most staggering part of the explosion of fictitious
capital was in the value of what are called derivative contracts. Of the $70bn in debt, about $11bn was ‘sold
on’ over and over again in various contracts derived from that debt. These derivatives, in essence bets on the
future value of a bond, a mortgage or a share, rose in value to a staggering
$550trn, or 11 times world annual output.
This made for easy money, allowing borrowers to buy
property, shares and other assets by the bucketful. But most of this expansion of credit was into unproductive
sectors of the capitalist economy – sure, it delivered jobs and income, but as
Marx explained, under capitalism, it was unproductive because it did not create
value that could be used to reinvest in new production and drive the economy
forward. Indeed, as more and more money
went into the stock or property markets, less and less was available for
investment in industry, new technology or better skills for the workforce.
As we have shown in this column before, it has been a
feature of modern capitalism in its declining phase for capital to be invested
more in unproductive rather than productive sectors. For example, the financial sector now contributes 30% of the
profits of capitalist businesses in the US.
Strip that away and the productive sectors of the economy are not doing
well. Indeed, the underlying rate of
profit has fallen over a period of decades, even though there are long periods
when it rises.
The credit crisis is the other side of the coin. Once the US property market began to
collapse from summer 2005 onwards, so the massive credit boom was revealed for
what it was – a fantasy, not based on real values.
Now the credit bubble has burst just like hi-tech dot com
bubble burst in 2000; and just like the savings and loans bubble in commercial
mortgages did in the mid 1980s in the US; and just like the credit bubble in Japan
did at the end of the 1980s.
Banks are now losing money hand over fist. So are the clever hedge funds and insurance
brokers. Credit is contracting fast, as
fictitious capital goes up in smoke and the real level of values is
revealed. This real value will be found
at a much lower level of production, employment and income – and of course, at
a much lower level of profit.
The collapse in credit will be just as severe over the next
few years as the expansion of fictitious capital was in the last five. And this time, the profit cycle is also in a
long-term downward cycle that still has some way to go to reach the
bottom. At the same time, we remain in
a long-term downward cycle for share prices, which express the confidence that
capitalists have in their own system.
Finally, the global property market is dropping too, not just in the US,
but also in the UK, Europe and later in parts of Asia.
Everywhere the arrows are pointing down for capitalism. This synchronised downturn in profitability,
credit, stock and property prices heralds a major economic slump by 2009-10, or
even earlier. The credit crunch will
lead to the worst global failure of capitalist production since 1980-2 and
perhaps even as bad as 1929-33.
