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What kind of crisis?

Hugo Radice delves through the layers of the financial crisis and lays out the challenges that any adequate alternatives have to meet
January 2009

The global credit crunch this autumn has now become an all-encompassing crisis of global capitalism. Governments in many countries have had to rescue their leading banks with massive injections of capital, while stock markets have crashed to levels not seen for 20 years or more.

So what is going on? Is this just a temporary crisis, largely restricted to the financial markets and the result of excessive risk-taking by US mortgage bankers, made worse by a minority of speculators in the mysterious world of hedge funds? Is it a broader crisis of the Anglo-Saxon neoliberal model of capitalism, leading to a return to greater state regulation and the curbing of speculative excesses? Is it an even broader crisis within global capitalism, requiring a new Bretton Woods-style conference to create a system of international economic governance that reflects the globalisation of economic life and the rise of new economic powers? Or is it a crisis of capitalism itself, an opportunity to put forward proposals that will encourage popular discussion of alternatives to the present order?

A speculative bubble?

Right up until September's spectacular busts on Wall Street and in Washington - Lehman Brothers, AIG, Fannie Mae and Freddie Mac - the consensus among academic economists, financiers and politicians was that the credit crunch was fundamentally down to risky mortgage lending to low-income households in the USA (the 'sub-prime' market) combined with the practice of securitisation by mortgage lenders.

These lenders found that they could package up sub-prime loans into tradable securities, and sell them on to investors. Because these mortgages had been taken out when interest rates were very low in the early 2000s, their repayment record when sold on was very good, with the result that the credit rating agencies gave the securitised loans a risk-free AAA rating. But as interest rates climbed from 2004 onwards, and real wages stagnated or fell for many poorer households, the number of mortgage defaults steadily rose, until it became clear that many of the securities based on the mortgages were now in effect valueless. Those who had bought the mortgage-based securities from banks and building societies now refused to continue doing so, with the result that banks like Northern Rock could no longer finance their planned lending.

None of this would have led to a general credit crisis, had it not been for the growth in importance in recent years of the inter-bank loan market. Historically, banks have always relied on short-term borrowing from each other to provide money to meet immediate needs, arising, for example, because of the timing of major loans or repayments. This market has its own interest rate, the London Interbank Offered Rate (LIBOR), and much of the lending was traditionally overnight or for a few days only.

But in the summer of 2007 the problem of 'toxic' mortgage debt, and the pyramid of financial derivative products associated with it, suddenly made banks realise that even these short-term inter-bank loans might be at risk, if a borrowing bank actually collapsed through insolvency. This is exactly what happened with Northern Rock: it could no longer find anyone willing to lend it the money to fund the mortgages that it had issued. After that collapse, banks in general became aware that they could not trust each other to remain solvent and repay their loans. The result was a freeze on inter-bank lending, forcing banks to restrict their credit provision more generally.

Over the subsequent months, the sub-prime crisis became more widely appreciated by bankers and investors. Stock markets began to identify those banks particularly at risk, driving down their share prices and making it impossible for them to raise funds in any of the usual ways, such as share issues. Stronger banks, meanwhile, sought to strengthen their balance sheets by injections of capital from wealthy investors, especially the sovereign wealth funds set up by governments in the oil-producing countries of the Middle East and the boom countries of Asia.

For a year or so from September 2007, it seemed that the sub-prime crisis could be contained. The restoration of confidence - to be signalled by a revival of inter-bank lending and a lower LIBOR rate - was delayed by occasional bank collapses, most notably that of Bear Stearns, a second-tier New York investment bank, in April 2008. But most commentators (myself included) expected that continuing dynamic growth in China and India would allow the world economy as a whole to 'grow out' of the crisis, with banks making sufficient profits from that growth to be able to write off their losses from the sub-prime crisis.

The continuing price rises in oil, minerals and foodstuffs could only be because global growth was going to continue. Indeed, this justified the view of both the Treasury and the Bank of England that inflation was still a serious threat, to be contained by keeping interest rates high. The September 2008 crashes largely discredited this optimistic scenario. Now this was no longer just a sub-prime mortgage crisis: it had become a general crisis of liquidity, in which any bank or investor with cash to invest felt unable to trust any borrower. This collapse in confidence threatened the entire global financial system.

A crisis of Anglo-Saxon neoliberalism?

That global financial system has, for the past 30 years, been transformed by the rise of neoliberalism. This economic ideology has been closely associated with the accession of Margaret Thatcher in Britain in 1979, and Ronald Reagan in the US in 1980. It represents a revival of the free-market, free-trade ideology of liberalism that was eclipsed by the Great Depression of the 1930s and the rise of Keynesian policies of state economic management.

During the 1970s, the post-war boom fizzled out with the return of mass unemployment and the appearance of high levels of inflation in much of the west. Conventional Keynesian remedies seemed powerless to address the unprecedented phenomenon of 'stagflation', and economics was transformed by the monetarist revolution led by Milton Friedman. Friedman argued that inflation was always and necessarily due to an excessive supply of money - 'too much money chasing too few goods'. This monetary excess was in turn said to be largely caused by excessive public spending, which had the further effect of 'crowding out' private investment by absorbing too big a share of available savings.

During the 1980s and 1990s, the new economic doctrine developed into a universal model for economic policy-makers, centred on the privatisation of the public sector, strict limits on public spending and borrowing, lower taxation and the deregulation of markets for labour, goods and credit. The model spread from its UK and US origins through its imposition first on much of the third world after the debt crisis of 1982, then on eastern Europe following the collapse of the state-socialist model in 1989, and finally on the European Union in the form of the 1992 Maastricht Treaty. By then, the model was widely known as the 'Washington Consensus'.

The widespread triumph of neoliberalism has been resisted in many ways in academia, in parliamentary politics and on the streets. Although neoliberalism is often derided for being doctrinaire - a 'one-size-fits-all approach' has been a common criticism - like all really hegemonic ideologies it has been applied very flexibly in practice, with substantial variation across countries in almost every element of the model. This is due not only to more or less effective resistance by its victims, but also to objective differences in national circumstances. Such differences arise partly from to variations in the size, living standards and degree of international integration of different economies, and partly from different inherited institutions and practices - for example, in trade union organisation or patterns of business finance.

This has led many progressive academics and commentators - see, for instance, Will Hutton in his book The State We're In (1994) - to identify an alternative 'organised' or 'coordinated market' model of advanced capitalism exemplified by Japan and Germany. Meanwhile, the travails of Africa and Latin America under the prescriptions of the Washington Consensus were contrasted with the successful east Asian 'developmental state' model of South Korea, Taiwan and later (for some writers) the People's Republic of China.

Through much of September 2008, the critics of neoliberalism were encouraged by the apparent limitation of the credit crunch to the USA and UK, albeit with echoes in other countries, such as Ireland and Spain, which had experienced rapid rises in house prices and home ownership. It seemed that the solution lay in adopting the alternative non-neoliberal model, and reversing the more extreme free-market policy changes such as the radical deregulation of financial markets.

By the end of that month, though, it was clear that banks the world over had been drawn into the financial black hole of securitised sub-prime mortgages and the beguiling attractions of 'Anglo-Saxon' financial practices more generally. For all the apparent differences in economic institutions and policy practice, the neoliberal approach had penetrated deeply into the crucial areas of credit provision and monetary management. As a result, however larger the role of the state might appear to have been in continental Europe or east Asia, their governments were equally incapable of decisive and effective public intervention.

This should not surprise us: whatever their institutional differences, the economies of 'non-Anglo-Saxon' countries are still governed by the principle of production for private profit, not for social need.

A crisis of globalisation?

As the financial crisis developed, the British and US authorities were driven to more and more desperate measures. As well as the emergency rescues of particular banks, in mid-September US Treasury Secretary Paulson proposed to allocate $700 billion of public funds to restore confidence by buying up the 'toxic debts' seen as responsible for the freezing-up of credit markets.

Ironically, this approach had been widely used in the former Soviet-bloc countries in the 1990s as they struggled to restore capitalism. But now, far from solving the problem, this only made matters worse. If the banks' estimates of their own balance sheets had lost all credibility, surely this was because neither they, nor 'the markets', had a clue as to the real extent of the losses they faced, and the 'true value' of the toxic debts. Clever economists proposed various forms of auction to establish a 'fair price', but that was no use at all if no one was buying at any price.

By the time Congress finally approved an amended package, with proposals to extend assistance to mortgage-defaulting householders as well as the banks, it was too little and too late. Stock market price falls obliged more and more banks and other financial institutions to revalue their holdings downwards, putting them in breach of one of the few remaining universal regulations - the requirement to maintain an adequate capital base to cover the possible withdrawal of deposits.

Thus the policy focus shifted towards the urgent need to recapitalise banks; and with few private investors (not even the sovereign wealth funds) willing to put up fresh capital, the only choice was for governments to do so, in exchange for substantial ownership stakes. Although Gordon Brown has been widely hailed as the architect of this new approach, it had been very successfully deployed in Sweden in 1992, and later with more limited success in Japan.

At this point, however, it quickly became clear - above all with the collapse of the bizarrely over-extended Icelandic banks - that ad hoc national intervention would simply transfer the pressure and the panic to the next country in line. Step forward, at long last, the International Monetary Fund (IMF), brainchild of the long-discredited John Maynard Keynes.

Ever since the devaluation of the dollar in 1971, and the subsequent explosive growth of global private finance, the IMF has been sidelined as far as the leading capitalist economies were concerned. Although it continued formally to coordinate balance of payments and exchange rate policies, its last significant loan to a G7 country was the British loan of 1976, long since repaid from North Sea oil revenues. Instead, the IMF's main role - in which it was later joined by the World Bank - has been to force the neoliberal model onto indebted third world countries through its conditional lending.

At the time of writing, a rapid succession of summits is under way, necessarily involving not just the G7 but Russia and other rising economic powers. The time now appears to be ripe for a substantial and significant restructuring of global economic and monetary governance. Meanwhile, the IMF has a growing cue of countries at its door begging for bail-outs, starting with Iceland, Hungary, Ukraine and Pakistan.

The crucial point here is that all previous banking crises have been essentially national in character, even if their solution has entailed loans from international institutions and policy coordination with other governments. The present crisis is clearly a global one, in the important sense of requiring a global solution. However, to see it as a crisis of globalisation would imply, first, that the crisis was particularly the result of globalisation, and second, that it is now both necessary and possible to roll back globalisation.

On the contrary, what we have come to call economic globalisation - the increased dependence of all capitalist economies on international trade, investment and finance - was a consequence, not a cause, of the neoliberal revolution. And going back to a world of greater national self-sufficiency, which was advocated by Keynes in 1933 not because it was a safer system but simply to deal with the collapse of international trade and finance after the 1929 crash, would involve enormous costs of adjustment, which we would all have to bear.

A crisis of capitalism?

Are we therefore witnessing a full-blown conventional capitalist crisis - albeit the first one that is truly global in scope? Certainly periodic crises in the 'real economy', in which economic growth comes to a halt, profits and investment fall away and unemployment rises, have been a key element in capitalism's perennial economic cycles, and it is normal for a credit crunch to signal the onset of such crises. The exuberance of the boom leads to overconfidence on the part of investors, and stock market speculation - using borrowed money - pushes share prices far beyond what could 'reasonably' be justified by future returns.

And that is just the point: given the pervasive uncertainty of capitalist markets, 'reason' plays second fiddle to what the great Keynesian economist Joan Robinson memorably termed 'animal spirits'. When a credit-fuelled boom falters, panic sets in as everyone seeks the relative security of money by selling whatever financial assets they can. But these financial assets - shares, bonds, mortgages, or nowadays a vast and incomprehensible range of so-called 'derivatives' - all have value only as a result of entitling the holder to a share in the profits generated by productive labour in the sectors that make goods and provide non-financial services.

In the end, it is the perception that these profits will be insufficient to cover the inflated expectations of investors that drives the panic selling. It appears as though the crisis originates in the 'financial' economy and then spreads to the 'real' economy; the reality is that the two remain always intimately connected, and it is in the 'real' economy that the crisis has both its origins and its resolution. In a system guided by private profit rather than social need, a serious crisis is always a crisis of profitability, and profits originate in the exploitation of productive labour.

So, at long last, we have come to the 'real world'. What has been presented to us all as a crisis of credit or of markets, unconnected to the everyday world of work, turns out to be a crisis of production. Firms respond to slowing sales growth by laying off workers and cancelling planned investments. The emphasis shifts to cutting costs and improving productivity, measures intended to raise profits for any given level of output.

Because all employers do this at the same time, there are rapid knock-on effects on retail sales, leading to further all-round declines in business orders. Today, because of much higher levels of international trade, these effects are spreading rapidly across global capitalism. The momentum of unprecedented economic growth in China and India, and the spending of the vast recent accumulations of money in oil- and minerals-producing states, can only mask the crisis for a while.

Given the dominance of consumer spending in total global demand, it is rising unemployment and increasing concerns about debt repayment that provide the focus of the next phase of the crisis. To offset falls in private consumption and investment, Keynes recommended an increase in public expenditure, to be financed by borrowing. In conditions of recession, this is by no means inflationary, as the monetarists allege. Investors of all kinds find that businesses and consumers now don't want to borrow from them, even when interest rates start to fall: the government is no longer the 'lender of last resort' to the struggling banks, but the borrower of last resort for those with money to invest - they prefer to buy government bonds with at least some return, rather than leave the cash idle and earning nothing.

Furthermore, it is certainly not the case that 'eventually taxes will have to be raised'. As and when recovery sets in, renewed economic growth generates an even faster recovery in revenues, given progressive income tax rates and stamp duty rates on house purchases, and rapid declines in spending on welfare benefits. And lastly, the claim raised by diehard monetarists, as in their letter to the Sunday Telegraph on 26 October, that governments are not competent to decide in which sectors to invest, is ridiculous: the present government proposes to bring forward infrastructural investments in transport, construction, education and training, which by definition will benefit all sectors.

Alternative solutions

It is tempting to see the crisis as an opportunity to replace capitalism with democratic socialism, and put forward the radical solutions that we would really like to see. But we need to be realistic, which means starting from the alternatives that are being put forward by the main political parties in Britain, by other governments and by international institutions.

First and foremost, despite its enthusiastic support for the delusionary ambitions of deregulated finance, New Labour led by Brown and Darling has proved to be unexpectedly decisive and flexible. The chancellor's Mais Lecture on 29 October set out a broadly Keynesian analysis that underlies the key elements in the government's new policy: first, abandoning the 'golden rules' of strict limits on public borrowing and expenditure; second, injecting new capital into the major banks in the form of temporary ownership stakes; and third, playing a major part in international efforts to coordinate the management of the crisis.

There is every opportunity for us to push for these measures to be oriented as far as possible towards the reining back of big finance and the protection of employment, production and incomes. While the models of 'coordinated capitalism' and the 'developmental state' have been seriously eroded in recent years, the state still has the capacity to override the fears and prejudices of the City and impose new institutions and policies.

Suddenly, it has become possible to put forward alternative ways of thinking. Both Keynes and Marx are back in vogue. Even if there is no ready-made model to replace neoliberalism, there is very widespread support for substantive changes in 'the system'. Four hundred years ago, the philosopher Sir Francis Bacon got it right: 'Money makes a good servant, but a bad master.'

Finally, where there are different options available in terms of concrete policy measures - which infrastructure projects, for example, or what areas of income support - then we need to argue for those choices that advance social justice, environmental sustainability and peace. These questions are taken up elsewhere in this issue.



Hugo Radice is a visiting research fellow at the University of Leeds, where he was the head of the Politics and International Studies school from 2004 to 2007


 

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