The Collapse of Capitalism?
Forrest Cookson explains the devastation in the US economy and surveys the fall-out
There is a saying that it is darkest just before dawn; but the inverse of that warns us that just when we are most successful, disaster strikes.
In the early 1930s, the industrial economies collapsed following an extravagant 1920s with excessive expansion of the financial system, misaligned exchange rates, a giant bubble in the American stock market, and a banking system in the United States that had gone without supervision.
The response to this, as the bubble burst, was to tighten credit availability, pushing the banking sector into collapse and sending the American economy and the world economy into a deep recession. Policy actions by the American government raised the real wage, reduced investment, and keep the American economy depressed until, finally, World War II led to dramatic expansion of expenditures by government and escape from a weak economic situation.
The initial attempts by the Roosevelt administration to raise wages by government decree caused a mismatch of wages to productivity that held up industrial revival for years. The key step of raising government expenditure never really took place until the war overcame conventional attitudes about the government deficit.
In this disaster, with the values of democracy and open markets at risk, Keynes formulated the key concept of using government deficits to offset declines in private demands. These ideas shaped economic policy of the industrial world after WWII and have been responsible for the continued expansion of the industrial economies. What failed was socialism. Keynes well understood that a system was needed, intermediate between the pure capitalistic model and the socialistic model.
Over most of the past 28 years, and most particularly over the past eight years in the United States, the idea that government is the balancer to maintain a steady but achievable growth has been abandoned as policies moved steadily to remove regulation of the financial system, to reduce the role of government, to reduce the stabilising influence of the government on the economy, and to pander to the greed of the upper classes.
These policies have brought the United States, Bangladesh, and the rest of the world to the brink of disaster. You may not realise it, but we are looking into the dark abyss of a collapsing international economy. Disaster is close, and it is far from clear if, or how, this can be avoided.
We now face an extravagant growth of the financial system, misaligned exchange rates, a giant bubble in the American housing market, and a system of non-banking financial institutions -- more important than commercial banks -- that is largely unregulated.
In the United States, there is no clear thinking on these issues; the Democrats are prescribing policies that will make things worse and the Republicans seem not to realise how difficult things are. The appropriate symbol for both of the political parties is an ostrich with its head buried and its backside pointed towards the future.
Smart people in the United States and Bangladesh are moving into cash and real assets as the value of financial assets is so uncertain. Liquidity is freezing up in both countries. What is our future?
The emergence of successful capitalist societies over the past 60 years stands in stark contrast to the failure of socialism. The past few years have seen the world economy growing strongly, vast reductions in the number of poor as China and India grew rapidly, and widespread success of market oriented economies: Europe, except for Russia, has transformed itself to new levels of economic prosperity and reduction of poverty. Of course, the income distribution became more unequal in most countries -- the higher income groups benefited from the increase in wealth more than the poor -- nevertheless, the poor are better off.
The consequence of this excellent performance was a growing demand for natural resources, particularly oil and gas, but the growth extended to all sorts of minerals and metallic products. The result has been rising prices of oil and minerals, a clear sign that continued rapid growth is not possible. Higher incomes have also led to greater demands for grains -- indirectly through eating more meat and fish, driving up wheat, maize, and rice prices.
Central to the success of the world economy over this decade has been the transfer of funds to the United States to enable that country to run a large current account deficit and consume vast amounts of goods imported from the rest of the world. That policy enabled many nations to expand their exports to the US, earning good money as they could sell at prices that were attractive to the US market but still far better than what could be obtained in domestic markets.
Further, the export bias enabled manufactures to capture economies of scale and to maintain quality, two achievements that would not be possible in the domestic market. Against all the textbook teaching that poor countries should borrow money from the rich, it turns out that the path to rapid growth is the opposite of that! Many find that hard to swallow, but all the countries that have grown rapidly have exported capital!
The American Housing Bubble
The inflow of capital into the United States, particularly from the Asian nations, effectively increased the funds available for investment. Where to make the investments? The US banks found themselves with large sums to invest. At first, in 2002, the US government deficit increased sharply, and the savings coming from the rest of the world were used to finance the expansion of US government expenditure and to replace the reduction in taxes. However, as time passed, the government deficit fell while the inflow of savings from Asia and the Middle East grew. The only way to deal with this was to encourage American households to borrow money. This led to a great increase of credit card debts, easy access to car loans, increased student loans, and most of all, increased lending for housing.
Two things happened: First, it became much easier to get a housing loan (mortgage) and second, the sizes of these loans were much larger. What would you expect to happen? People selling their house found that the price offers were rising as so many people were able to get housing loans. The construction industry responded by building houses as rapidly as possible.
With so many persons anxious to buy a house, the price of houses rose rapidly. It takes time for the construction sector to build houses so the rising demand influenced prices immediately for houses already built; the construction sector built houses as fast as possible but that led to higher construction costs and prices kept on rising. In addition, the spurt in construction resulted in the price of construction materials needed for the houses and apartment building also rising, adding further to the construction costs. Up went housing prices, up went the construction sector, and up went the lending to households to buy houses.
In the American financial system there are two large institutions, now called Fannie Mae and Freddie Mac, both of which had originated as government organisations to help fund housing, but were privatised as part of the financial sector reforms.
They worked in two ways: First they purchased mortgages made by banks, thus refinancing the lending bank and enabling them to make still more loans. Second, they guaranteed mortgages so that the lending bank did not face any risk and could cover its potential loss from default by paying the insurance premium to these two insurers. This pooling of the risk meant that lower interest rates could be made available to the guy that wanted to buy a house.
These two organisations got their money by borrowing from the capital markets. They borrowed from central banks around the world with the encouragement of the US Treasury, which assured everyone that this was as sound as a US government security. This channeled substantial foreign saving into the mortgage market in the United States, enabling more and more money to be directed to housing.
Those housing loans that went through Fannie and Freddie were called "prime" mortgages as they all met certain criteria laid down with respect to the size of the loan, relationship of income of borrower to the size of the loan, percent of the purchase price that could be covered, provision for insurance, and other technical rules related to construction.
But the availability of funds from the foreign lending to the US was so great that the financial institutions needed to increase the amount of lending and, hence, the so-called "sub-prime" mortgage market emerged. This market comprised loans that did not meet the conditions of Fannie or Freddie and so were generally riskier1. Of course, such sub-prime loans could not be refinanced through the two institutions.
Another method was devised whereby the sub-prime mortgages were bundled together and, in complicated ways, financial instruments were devised so that persons who wanted to purchase these could buy instruments that had low or high risk. The higher the risk, of course, the higher the return offered. In this way, the sub-prime mortgages as well as the prime of conforming mortgages were refinanced.
As the prices of houses increased, Americans found that their houses were much more valuable. For example, I bought a house for $300,000 in 1995. I took a mortgage for 20 years for $250,000 and paid from my savings for the rest. In 2003, I had repaid $50,000 of the principal, so I owed $200,000. But the market value of the house had increased to $450,000. The bank will allow me to borrow 80% of the value of the house or $360,000; I owed $200,000 so I could borrow another $160,000 as a home equity loan. I did this, borrowing $100,000, which I used to buy a car ($40,000) and to make the down payment on a summer home that cost $300,000 (I paid $60,000 in cash and borrowed the rest). Now, I owed $540,000 altogether, and by purchasing a second house I added to demand in the housing sector. That was what upper-middle class Americans were doing.
The financial institutions had a lot of funds to lend. The intermediation set up a system to get funds to the banks that were actually making the loans to home buyers and developers who were building new housing. Interest rates were low, so everyone wanted a house or a second house. This drove the expansion of the American economy. Everyone is happy -- foreign investors, foreign central banks, American financial institutions, and the American public.
Of course, it was overdone on the boundaries, and loans were made to households that could not afford to repay. Much crooked activity took place. Respectable banks left this to brokers who made the doubted loans for them. Many lower-middle class Americans got in too deep and soon faced problems making the payments for their homes. But many also managed to own a house for the first time and felt proud to be property owners.
Everything is going up, house prices, demand for housing, building new houses, lending, and profits for financial institutions. The access to home equity lending enabled Americans to buy cars, send their kids to increasingly expensive colleges, take vacations, buy large screen television sets, etc etc.
The student loans for college worked much the same way. Improved financing increased the demand for college education; colleges raised their prices in the face of demand increases. Students borrowed more money. The financial institutions bundled the student loans and refinanced these. The US government provided some guarantees for some of these loans. Great -- more people went to colleges, colleges made a lot of money and built better facilities or raised their professors' salaries. Students borrowed more money to get educated, believing that when they graduated they would make a lot of money to pay off the loans.
Through such factors, lending rose and rose, and American households became more and more in debt. Life was good. The rising values of homes reduced the risk to the lenders, provided a cushion for old age for home owners or a ready source of financing through home equity for education, vacations or whatever you wanted. The rest of the world worked hard making things, sent money to the US, the US financial institutions spread this money around so that the stuff the rest of the world was making could be sold to the Americans.
Everyone is happy. The Chinese business community is making good money; the Chinese household is able to save, the Chinese economy is growing fast in response to the high level of demands. Central banks send their money to the US, and in doing so keep their currency depreciated so that they are competitive in selling in the US. The head spins at the beauty of the system. But all depended on the continued borrowing by American households.
Of course, intelligent people could see that this could not last. Housing prices were unrealistic when compared to the earning power of the owners of the houses. Only continued increases in housing prices could sustain this wonder.
Consequences of the Collapse of the Bubble
In 2007, this paradise began to crumble, and we are now in the middle of the unwinding and collapse of the structure that has been built. Several things happened more or less in conjunction: The mortgage market in the United States had built in increases in interest rates, suddenly increasing the required payment; as the market for housing weakened the increase in house prices stopped, and it became more difficult to use home equity financing as a cushion. At the same time the American economy slowed somewhat, making it even more difficult as people lost jobs, and bonuses and overtime were reduced. There were dramatic increases in the prices of food and gasoline, undermining consumer purchasing power. These price increases also arose from the high demand levels in a rapidly growing world economy.
Expenditures that had been linked to income and home equity loans now slowed with a weakened economy and the closing of the markets for home equity loans. The Federal Reserve lowered interest rates quickly to try to maintain aggregate demand. This had the effect of reducing capital flows into the US but did not really affect the private consumption expenditures as banks did not lower interest rates to consumers, and instead in-creased them! The reduced capital inflows contributed to a weakening of the US dollar, resulting in reduced imports, higher oil prices around the world, and increased US exports. Internally, the weaker dollar helped American producers of exports but higher gasoline prices hurt households.
Investment weakened sharply in housing, and somewhat in commercial construction and purchase of machinery. As private consumption expenditures weakened, exports rose. The net effect was to slow the growth of the American economy, although it remains positive.
As the world economy slowed down and some conflict zones in Iran and Georgia looked increasingly dangerous, funds flowed back to the US for precautionary purposes, the dollar strengthened, and gasoline prices fell, so things got a little better. But the underlying reality is weak US private consumption demand, weak investment in housing, weak import demand, high oil prices and a weak dollar.
This has strong implications for the rest of the world, and the naïve ideas that Asia could escape from the impact of the US slowdown we now recognise as wrong. In Asia the Japanese, Indian and Chinese economies are all slowing. Export growth is weaker, inflation is impacting private consumption expenditures, so overall aggregate demand is now reduced, and it is uncertain if this can be countered by domestic demand increases. Certainly, Japan has been unable to achieve this and the Japanese economy continues to rely heavily on export markets. The impact on China and India is clear, as both economies slow while inflation increases. The major European economies are also experiencing slower growth. The major industrial economies are down near zero GDP growth.
Why have the world's financial institutions run into such trouble over the default of a small percentage of the housing loans in America?
The Great Escape
To understand this, one has to see the great changes that have taken place in the world's financial institutions. I call this the "Great Escape." Central banks have diligently tried to supervise and monitor commercial banks to insure that the depositors' money was safeguarded. This effort has apparently been successful, with few bank failures, and most central banks were able to respond correctly and promptly to commercial banks' problems.
But groups and families with deep financial pockets were looking for better returns and other ways to earn safely, without the risks of the share markets or the low returns from bank deposits. They needed to escape from the regulatory regimes. Funds were accumulating in insurance companies, pension funds, and private fortunes that sought investment opportunities. There began the proliferation of financial instruments that sought to refinance commercial banks and corporations by lending money through special type of instruments.
The most interesting of these was the bundling together of a lot of debt from car loans, credit cards, and house loans. By finding ways to group these together and sell the loans the commercial banks are refinanced and can lend more.
These are called collateralised debt obligations (CDOs). CDOs are put together in complex patterns so investors can choose the mix of risk and return that they want. If the mortgages are all "prime" then Fannie Mae or Freddie Mae may buy them. They did so in large amounts.
As the value of these CDOs declined with rising defaults by home owners the two financial institutions saw their assets fall, eroding their capital and forcing them to seek more. But their share values declined, and replenishing capital became too difficult. Heading towards insolvency and the collapse of the world financial system they were taken over by the US government.
In Bangladesh, a commercial bank has for its liabilities deposits, borrowing from other banks (which of course cancel out in the aggregate), and borrowing from the central bank. The banks have only begun to securitise their loans -- bundling them together -- and lending them to, say, a provident fund. But in the western world this became the central idea of financial institutions. These types of instruments will have higher interest rates than deposits, and so attract funds that are tired of the low return on bank deposits or government securities.
Once this idea is loose in the financial world it can keep on expanding. Any financial institution can take its assets, bundle them together and sell that to some other financial institution. One builds a higher and higher tree of assets and instruments. Somewhere at the bottom of this tree are the actual loans connected with the real economy -- the house loan, the car loan, the equipment lease, the credit card facility. But on top of this are endless financial instruments built on whatever assets one has.
The difficulty is obvious -- it is hard to assess the risk of these CDOs. Particularly for CDOs linked to the sub-prime market, but not restricted to those assets, there grew credit default swaps (CDS). Company A wants to buy a CDO from Company B; but Company A wants insurance against default. Company C offers this insurance in return for a fee. If there is a default then Company C pays Company A. Company A also demands collateral from Company C to insure the obligation is meant.
The CDS market is a vast, complex network of these insurance-like agreements. Estimates of its size range from $5 trillion to $40 trillion! Unlike insurance there is no fund set aside, often only some of the company assets. For example, the large insurance company AIG had about $50 billion of these CDS agreements; it received payment of the fees for these and the assets of the company (largely shares of its subsidiaries) were collateral. The CDO and CDS markets expanded rapidly. Actually, no one really knows the extent of all of this.
Now consider what happens when the loans at the bottom of the tree begin to go bad. Everything else begins to go bad with them. But no one knows how much. If I default on a house mortgage it reduces the value of the bundle of house mortgages that my particular loan is bundled into. If the institution that got that bundle has bundled it with other things and sold that off my little house loan has now reduced the value of still another financial instrument. But no one knows which one or how much.
Suddenly, financial institutions do not know how to value their liabilities and assets. Such institutions then become very conservative. They do two things: First, they write down the value of their assets to protect themselves. Second, they stop making risky loans and seek to place their funds in as safe a vehicle as possible.
Writing down the value of their assets gives them protection against things getting worse -- nobody knows -- and they can always recover this if they find that they have marked down their assets too much. Since most managers do not get punished when the values go down, but get rewarded when they go up, this is the way to make money if you run a financial institution.
We can now see the results. Fanny Mae and Freddie Mac have been taken over by the United States government and funds supplied to insure that the two mortgage banks could continue to have sufficient capital, to meet their payments, and continue to fund housing.
There were five investment banks in the United States -- basically unregulated; these took in funds and invested them, much in CDOs, bundled CDOs together to make another CDO to sell, and so forth. As the mortgage payments slowed, CDOs lost value, investment bank assets fell, their share prices fell and they could not raise needed capital.
One of the banks has collapsed, two have been taken over by large commercial banks, and one is in discussion with another commercial bank to sell itself. With the threat of default on the CDOs, AIG was faced with very large potential payments and was taken over by the United States government to prevent this from happening.
Faith in the Financial System is Collapsing.
In conclusion, we have a weakening US economy arising from the housing bubble, the financial markets freezing up as it becomes so difficult to evaluate the quality of assets, American households holding excessive debt and now moving to adjust such debt by reducing consumption, while higher prices further reduce real disposable income.
Although the US national accounts data does not yet show these effects on private consumption it is likely that adjustments in the accounts made over the next few months will show weaker private consumption expenditures. It is likely that aggregate demand in the United States will be weak for one or two more years. Inflation fears may well persuade the Federal Reserve to raise interest rates. This will protect the dollar, reduce inflation, slow investment, reduce export growth; on balance this will reduce GDP growth so as to achieve lower inflation.
The weak American economy will affect the rest of the world through reduced imports and higher exports. This will induce slower growth in Europe, Japan, China and India. However, these cumulative effects will reduce the pressure on the price of oil, which will continue to decline. World financial institutions will continue to struggle to understand the real value of their assets.
Will the situation continue to get worse, or can we expect recovery in the next two years? The key to this is the financial sector. Having failed to regulate the financial sector at this point, no one has any clear idea as to what is happening. The most likely direction is a worsening of the condition of the financial institutions; the real economy may be all right but the financial condition of these institutions is more difficult to manage. It is on this that the future rests. If the financial institutions continue to deteriorate then full recovery may be many years away.
How ironic that all the great banks, that have been telling the world what to do, have now been shown to be naked. How ironic that the IMF, explaining to nations like Bangladesh how to run their financial systems, completely failed to warn of the tangle into which the American and European financial institutions have gotten themselves.
Can We Get Out of This?
The world's real economy will recover if the US current account deficit becomes larger and the dollar gets stronger. This will return us to the world of one year ago, when the US economy was absorbing the excess saving of Asia and the Middle East. But how is this saving to be absorbed?
The answer is that the US government must run a larger deficit. This is easy to do, as expenditures on infrastructure, energy security, and health care are needed. There is a great deal of money that needs to be spent: to improve the infrastructure in the United States, to rebuild cities, to support renewable energies particularly solar and wind generated electricity, to improve transport systems, to build more hospitals, train more doctors, train more nurses, build up integrated medical records, etc.
But this must be done with some flexibility: For example, the expenditures on such items should be driven by the size of the excess Asian and Middle Eastern savings defined by the change of the foreign exchange reserves held by a group of Asian and Middle Eastern countries.
Similarly, there must be a major increase in the regulation and supervision of financial institutions; the institutions hate such a thought but having all but destroyed us they deserve no mercy. No one knows exactly what to do, but the experts will think of something. The pendulum has swung too far towards no supervision, and needs to reverse itself. For sure this will happen in the United States and the UK, but how it will end up is uncertain. The financial institutions will fight such regulation and supervision as hard as they can.
The only difficulty is the American political system is focused on reducing the government deficit. Just listen to the speeches by the candidates for the presidency. I believe that the deficit will increase, but it is possible that American politicians will get serious about deficit reduction. If they do, the world economy will remain in a weakened state
Impact on Bangladesh
The most important thing for Bangladesh's economic future is to maintain export growth and to diversify the types of exports. This will not be easy during the next five years, given all the problems discussed in this article. But this I think should be the front line of development policy. It is not business as usual!
We may see in the next year a serious decline in exports as the European and American markets weaken. The apparel sector probably faces a terrible year. All of the joy now being expressed is hope flying in the face of reality. At present exchange rates the apparel sector could be largely bankrupt in 12 months.
Bangladesh can be competitive, but there are urgent actions to keep in mind.
The exchange rate should be maintained at a level that supports competitiveness of exports. That requires a significant depreciation.
Particular problems of export sectors should be tackled in a serious way. This is simply not being done; instead there are a lot of promises and words but little happens. Examples: proper testing of shrimp for contamination, cleaning up the environmental disaster of the tanneries, putting the jute sector on a proper basis uncontaminated by SOEs, easing the exchange control regulations, simplifying customs administration, and building the port and railway facilities needed for a massive growth of industrial exports.
The Bangladesh financial system must do a much better job of working with export companies. The banks and the courts must do a better job of forcing exit on failing companies. The failure to do so allows companies to operate when they are bankrupt. This leads to unrealistic competition and undermines industry.
Another area of concern is financing of the energy sector. The current more conservative posture of the international commercial banks makes financing of such profits more difficult. The international oil companies do not face such problems, but IPP projects certainly do. Three years ago, financing $1 billion worth of projects in the power sector would have been straightforward; the changed conditions make this much more difficult and more expensive.
Finally, we come to foreign investment. As for portfolio investment, this may well increase. Anything is possible. For FDI in manufacturing we would expect a dramatic increase; costs are rising rapidly in other countries, and one of the best cost saving actions a company can take is to move to Bangladesh!
1. Very large loans above the prime loan limit made to persons with the highest credit rating were also "sub-prime" as they did not conform for being too large
Forrest Cookson is an economist.