Economy

The US Financial Crisis: Collapsing Sand Castles ARUN KUMAR * Since August 2007 the crisis in the US financial system is big news. It is the deepest crisis in the last eighty years. Initially, the US establishment denied that there was a crisis. A deteriorating situation forced a financial package of tax cuts and bail out of Bear Sterns.

Then came the crisis of the two housing mortgage giants, Freddie Mac and Fannie Mae. After much dithering the government took over these two companies to prevent a collapse of the US financial system. From not admitting to a crisis to accepting that if it did not act, the whole financial  system could collapse was a long journey for an admittedly right wing government that has preached to the rest of the world the powers of free markets.

There followed a sigh of relief in the financial markets that they had escaped the inevitable collapse. But that was premature since three of the biggest global financial players collapsed. Lehman Brothers filed for bankruptcy; no one was willing to buy/bail it out. Merrill Lynch was sold to BankAm for a bargain price and AIG was almost on the verge of collapse and with that it appeared much of the financial system was teetering on the brink. Again after dithering, the US government stepped in by putting together a bail out package. The markets recovered.

However, confidence was now at such a low ebb that no one was willing to trust anyone else and lend to them. This has undermined the financial systems because they run on trust between institutions that lend and borrow amongst themselves. There exist layers upon layers of financial assets with little solidity because all the actors were building castles in the air and convincing each other that they were solid - much like the kings clothes which did not exist.

The inevitability of a collapse of the US financial edifice is now apparent to the policy makers in Washington and the financial institutions all over the world. Hence the US government and the Legislature are putting together a massive $700 billion bail out package for the financial industry. Counting all the bail outs in the last one year, the government is giving to the financial institutions about $ 1 trillion. This is about $3,000 per US citizen or more than India’s annual production.

However, trouble continues to brew since it is not clear how this bail out package will work? How will the assets be priced in a market where their prices are collapsing? If they are bought at higher than current prices, it would be seen as a dole to the super rich financial players. If the assets are priced at current prices, the crisis would continue with more institutions failing over time. Indeed, news is that Washington Mutual is also going under.

Perceptive analysts have been pointing out that unregulated financial systems are a bubble waiting to burst. Keynes had pointed to this danger and so had Minsky in the late seventies.

However, increasingly over the last 50 years it is the world of finance that had become politically and economically powerful and it manipulated policies to have its functioning more and more deregulated. This accelerated with the onset of Thacherism in the late Seventies. In the Nineties, Greenspan the ruling US deity propagated this philosophy and believed that markets are self correcting – how erroneous.

Diehards suggest that the US government is turning socialistic. But, the bail out is for the private financial markets to stem problems for the real economy. Subsidies are for the rich and not the poor.

The real economy had been suffering due to the collapse of the housing markets, rise in food and energy prices and the consequent decline of the automobile industry etc. Since January, more than 700,000 jobs have been lost. This decline in the real economy is linked to the growing financial crisis - a two way linkage.

An understanding of the functioning of the financial markets will help analyse the reasons for the collapse. Money is created by deposits and their lending in the commercial banking system. For security, a certain percent of the deposits are held in the Central bank which acts as the lender of last resort guaranteeing the entire system. This assures the depositors that their money is safe and they can get it back when needed. The banks are regulated by the Central bank so that they follow prudential norms.

Outside this regulated system, newer financial institutions, like the Investment banks emerged which started trading in financial instruments. They used their own funds and those of their clients to leverage more funds and buy financial assets. High profitability was assured as long as the prices of assets rose. The movement of funds in the financial markets were hundreds of times greater than the real output. The profits of the financial sector were based both on squeezing the surplus out of the real economy and by creating a speculative bubble which yielded capital gains.

This was an unstable situation. If, for any reason, the asset prices declined then just as huge profits were generated, big losses would follow. Billions of dollars of capital of Bear Stearns, Fannie Mae, Freddie Mac and Lehman Brothers was wiped out in short time and they had to go for sale or bankruptcy.

Three additional factors need to be factored in. First, the low savings rate of the US economy which has meant that the rest of the world holds a large part of the capital in the USA. Secondly, the war in Iraq and Afghanistan has been bleeding the US economy and eroding its asset base. Finally, super profits have been spirited out to off shore banking channels (of which there are 77). Thus, the financial bubble has been backed by a smaller and smaller base of real output and US owned assets.

All this was leading to the decline of the dollar, thereby aggravating the crisis for the US because the rest of the world started to move away from the dollar. This weakened dollars status as a reserve currency. The USA is not able to export its deficits as easily as earlier. The swelling bubble had a crumbling base and the US economy fell into a vicious trap so that even a small disturbance was enough to deflate the financial bubble. The trigger was the collapse of the housing market followed by the sub-prime crisis.

The above also explains why it is the US financial system that has faced a crisis and not that in other developed countries. However, given the global reach of the US financial system and the integration of the markets, the crisis will hit other economies including those of the developing countries. India will be no exception (See the author’s article in these columns, February 6, 2008) with its stock markets in turmoil, FIIs withdrawing money and the leveraged buying by cash rich companies likely to face a crisis.

In brief, given that the US financial assets are backed by a small real base the government bail out worth $ 700 billion is unlikely to stem the crisis. The US budget deficit is likely to balloon and create fresh problems since the rest of the world is unlikely to hold this uncertain asset which can also collapse. The crisis is systemic and a Tsunami is moving in.

Dr. Arun Kumar is the Coordinator of the EXIM Bank-JNU Library in Economics. He is teaching Economics in Jawaharlal Nehru University since 1984. He has been the Chairperson of the Centre for Economic Studies and Planning of JNU, Vice President and Acting President of the Indian Academy of Social Sciences (ISSA). This article was first published in The Tribune, September 30, 2008.