As I write, financial markets in Wall
Street, New York, the City of London and all over are in turmoil. In just 24 hours, two out of the four largest
investment banks in the US have disappeared.
Lehman Brothers, around for 158 years, has declared bankruptcy and
25,000 employees around the globe have lost their jobs.
Merrill Lynch, the world’s largest
investment bank, has been taken over by the largest high street bank in
America, the Bank of America. Bank
America was virtually ordered by the US financial authorities to take over
Merrill Lynch, paying $50bn. Otherwise,
that bank too would have gone bust, putting thousands more out of work. Even worse for capitalism, it would have
meant that both Lehman and Merrill Lynch would have defaulted on their contracts
and obligations and thus brought down many other banks (15 were rumoured to be
Along with Bear Stearns (wiped last March),
three out of the top five investment banks in the US have vanished in a puff of
And finally, America’s largest insurance
company, AIG, announced that it needed to raise $40bn within hours if it was
not to default on its obligations and appealed to the Federal Reserve for a
loan before it was too late!
All this took place only one week after the
world’s largest semi-government mortgage lenders Fannie Mae and Freddie Mac had
to be nationalised to protect American homeowners and the mortgage industry
from going bust. These two lenders had
over 40% of all mortgages in the US and 85% of recent new mortgages. It would have meant the total collapse of the
housing market if they could not do business.
So the Bush administration was forced to nationalise them!
How did this terrible mess for capitalism
The capitalist economists have no real idea. Some say it is the fault of greedy chief
executives of the banks who gone into reckless investments and lent too much
money to people who could not pay it back.
Some say it is the fault of the Federal Reserve and other central banks
for keeping interest rates too low and thus encouraging too many people to
borrow too much or too many banks to lend too much. Others say it was the failure of the central
banks to ‘regulate’ the banks and investment houses to make sure they had
enough funds to do their business instead of borrowing to lend etc.
But perhaps the story of the British travel
agent XL, which also collapsed this week, leaving hundreds without jobs and
tens of thousands unable to get home from their holidays, has the most
interesting clues to why this global financial tsunami is sweeping away so many
big financial institutions.
XL chief executive explained tearfully to
the press that his company had gone under without warning for two reasons: the
sharp rise in the price of oil had dramatically increased the company’s costs
for air fuel; but when he tried to raise more finance to cover this, he was
unable to get any banks to provide funding at rates or terms that made it
viable to continue. And there we have
it. Such is the stranglehold and fear in
the global credit crunch that banks are no longer willing to lend money at
reasonable rates or on reasonable conditions to businesses. And those that are hard pressed are forced
into bankruptcy – expect much more of this over the next year.
Why are the banks unable to lend? It’s because they have lost so much money on
the writing down of the assets they have bought over the last five or six
years. Now they must retrench and stop
lending. Now they must find new capital
and investors before they can start relending.
In the meantime, they are too scared or unwilling to lend, even to other
banks (that’s why Bear Stearns, Lehman, Northern Rock and others went bust –
nobody would lend to them).
What are these assets that have lost so
much value? In the main, they are called
mortgage-backed securities. In the old
days of the housing market, banks or building societies would attract cash
deposits from savers like you and me (we should be so lucky!) and then use these
deposits to lend to people who wanted to buy a home. From deposit to mortgage – simple.
However, some bankers started to be more ‘innovative’
in order to make more profits. They
started to borrow funds from other banks and then lend that on mortgages. This ‘wholesale funding’ became particularly
popular with US and UK banks, like Northern Rock, which had been a rather
sleepy building society until the mid-1990s when it converted into a ‘bank’
with shareholders and an aggressive management out to make money for its
investors (not savers).
But that was not the end of it. Many banks came up with another wheeze. They would take their mortgages and batch
them up into a basket of different quality mortgages which they would sell off
as a bond or security to other banks or financial investors. By creating these securities and selling them
off, they ‘diversified’ their risk to others.
Also they set up separate companies that took all these liabilities
completely off their books. That meant
they could go out and borrow more and do more mortgage business. Soon many banks that used to have enough cash
and stocks to match at least 10% of the loans, now had reduced that to just 5%,
or in the case of the big American banks and mortgage lenders to just 2%. Leverage was now 50 times, the money the banks
actually had to meet any losses.
But no problem – the US housing market was
racing upwards. So as fast as banks lent
money, they made it back in the rising house prices. Home owners could afford to pay them back and
take out even bigger loans. Banks could
lend to people who hardly had any income because they could count on the value
of the home rising to cover their loan.
But then it all went horribly wrong. From about 2006, house price rises began to
slow and then began to fall. Once house
prices headed downwards, so did the ability of mortgage borrowers to pay back
their loans and their willingness to take out bigger and better mortgages. The mortgage market slumped. Soon the mortgage lenders were losing money
and behind them, the owners of all these mortgage-backed securities found that
their ‘assets’ were no worth what they paid for them. And just everybody and his dog in the
financial world had these securities. The
risk had been diversified so that everybody got hit when things went wrong.
Why did the housing market go down? Why did it not carry on in a straight line
upwards and it had done for nearly 18 years?
I venture an answer. First, there
are cycles of motion that operate under modern capitalism. The most important law of motion under
capitalism is profitability. As Marx
showed, the rate of profit is key to investment and growth in a capitalist
system: no profit, no investment and no income and jobs. But profitability moves in cycles: for a
period, profitability will rise, but then it will start to fall. In previous articles, I have tried to explain
how that pans out.
But the profit cycle is not the only cycle
of motion under capitalism. There is
also a cycle in real estate prices and construction. The real estate cycle seems to last about 18
years from trough to trough.
There appears to be a cycle of about 18
years based on the movement of real estate prices. The American economist Simon Kuznets
discovered the existence of this cycle back in the 1930s. We can measure the cycle in the US by looking
at house prices. The first peak after
1945 was in 1951. The prices fell back
to a trough in 1958. Prices then rose to
a new peak in 1969 before slumping back to another trough in 1971. The next peak was in 1979-80 and the next
trough was in 1991. The spacing between
peak to peak to trough to trough varies considerably. It can be as little as 11 years or as much as
26 years. But if you go far enough back
(into the19th century), the average seems to be about 18 years.
The last peak in US
real estate prices was in 1988. Assuming
an average cycle of 18 years, then house prices should have peaked in
2006. The last trough was in 1991. Assuming an 18-year cycle, then the next
trough in US house prices should be around 2009-10.
The real estate cycle does not operate
not in line with the Marxist profit cycle.
The latter is a product of the laws of motion of capitalist
accumulation. It operates in the
productive sector of the economy (and by that, I mean ‘productive’ in the Marxist sense, namely contributing to the production of value).
In contrast, the real estate cycle operates
in the unproductive sector of the capitalist economy. New value created and surplus-value
appropriated in the productive sectors of the capitalist economy are siphoned
off by the unproductive sectors as the owners of capital spend their profits
and workers spend their wages. Housing
is a big user of consumer income. So the
cycle in house prices reflects the spending behaviour of capitalists and
workers, not the profitability of capital.
For these reasons, the real estate cycle
has different timings in its turns than the profit cycle. As I have explained before, the profit cycle
reached a trough in 1982 before rising for 15-16 years to peak in 1997. In contrast, the US real estate cycle
troughed some nine years later in 1991 and only reached its peak in
2006-7. The next trough is due no earlier
This huge rise in house prices, exhibited
around many parts of the world as well as the US, represented a massive
diversion of resources by capitalism into unproductive sectors that produced no
new profit through investment in technology and productive labour. As a result, it actually reduced the ability
of capitalism to invest in new technology to boost economic growth. It was entirely a process of creating
fictitious capital. That is shown buy
one stark fact. You can measure the
movement of house prices from 1991 to 2006.
In 1991, the US house price index stood at 100; by 2006, it had reached
200, a doubling in price. But the costs
of building a house including land purchase had not risen at all. So house prices were way out of line with the
real production value of a home. The
housing market had become a huge financial speculation. When home prices got so far out of line with
the incomes of those who were buying them, the market finally toppled
Capitalism does not operate in a smooth and
steadily increasing way to progress. It
operates violently, lopsidedly, in cycles of boom and slump. The path of chaos and anarchy applies to the
cycle of profit and also to the cycle of housing construction.
So what now? Well, more banks are set to fail. There will be more misery in the financial
markets. More to the point for working
people not worried about whether rich investors lose money, jobs throughout the
financial services industry are going to go.
And we are not talking about the fat cats at the top who caused this
mess – they will leave with the payoff and pensions intact. We are talking about the tens of thousands on
moderate pay packets who put all their savings into the shares of the banks
they worked in, and which are now worthless.
And more, the collapse of the financial
sector will lead to a serious economic downturn. It is already underway with the US, the UK,
Europe and Japan going into economic slump, where output will stop increasing,
companies will fail and unemployment and inflation will rise sharply.
The politicians are lost in all this. Whether it is a right-wing Republican
administration or New Labour, they know not what to do. Indeed, in many ways New Labour has been so
tied to the model of American capitalism with its ‘free choice’ and ‘open
deregulated markets’ that it is even more in denial than the Republicans. In America, they have nationalised the
mortgage lenders. In Britain, they just
look shocked and babble about the ‘worst crisis in 60 years’.
Eventually, capitalism will recover, unless
governments come to power mandated to end the rule of capital. But it will recover only by restoring
profitability. To do that, many jobs
must go and many companies must be swallowed up by richer ones. That process has started in the financial
sector. It will continue across the