Chapter Sixteen: The International Financial System
A major development came about in the l970s with the financial revolution, the global liberalization of financial flows. The removal of capital controls freed up the global movement of capital. The result was the increased integration of national capital markets and the creation of a global financial system. The international financial market which emerged, however, greatly increased the instability of the international economy and increased the risk of financial crises. The interval between financial crises has been getting shorter and their impact on the global economy has been getting worse. In Mexico the l981 financial crisis resulted in a four percent drop in output. In Indonesia in 1998, output dropped by fourteen percent. In Greece in 2010, output plummeted by twenty-three percent. Between 1945 and 1975, on the other hand, the world financial system was practically crisis-free. This was mostly due to the limits on financial flows.
In the late 1970s, bankers pushed for financial liberalization. Financial flows were freed up and Eurodollars were recycled to Latin American countries as loans. The problem came with the sudden stop. When the money stopped coming, financial crises emerged. The same pattern was seen in the East Asian Financial Crisis in l997. Again this was seen in Greece, Spain and Portugal in 2010.
Liberal economists argue that the financial revolution has made the use of capital resources more efficient. This argument is disputed by those who see the global economy increasingly as a casino economy and vulnerable to financial crises.
Global financial flows have increased by leaps and bounds since the l970s. The rate of daily turnover in currency exchanges has jumped from only 15 billion US dollars in l973 to 1.2 trillion dollars in 1995 and 5.3 trillion dollars in 2013. In the l980s, financial flows were some five percent of advanced country GDP. This increased to twenty-five percent by 2008, but fell back to ten percent in 2010, after the financial crises in the United States and Europe. Financial flows had become some 100 times the volume of trade flows by 2013. Billions of dollars were being moved from one economy to another at the touch of a button. The equity and bond markets have also become global. This is an extension of the financialization of the US economy which has taken place since the l970s. Great profits are being made in the financial sector of the economy.
Historically, financial flows from Great Britain between 1880 and 1910 averaged about five percent of GNP. Before World War I, British investments funded universities and railroads, port facilities and other infrastructural projects in the United States. Financial flows from the British Empire helped to increase growth in the United States in the form of long-term investment in the late nineteenth century. Today, in contrast, international financial flows tend to be short term and highly speculative. Much of this volume of capital flow is what is known as “hot money,” capital seeking higher interest rates, or arbitrage, in the global economy. When the danger of economic crisis seems eminent, this capital can flee a country overnight, consolidating the crisis.
In this global financial casino, some countries such as Japan, China and India still maintain controls on financial flows. Turkey is more liberal than these three countries and so the Turkish Lira is more vulnerable to financial flows. The central bank can manage exchange rates in normal times, but can easily lose control with wide fluctuations in the financial markets. While Turkey has benefited from the US policy of quantitative easing (QE) between 2008 and 2014, this puts more pressure on the currency when the US eases back on this policy, as in 2014. The US began a tapering policy in early 2014 which caused emerging country currencies to drop sharply in relation to the dollar and the Euro.
There are several conditions which are frequently associated with a financial crisis. The most vulnerable countries are in the developing world. However, not even the United States, Greece, Spain, the East Asian tigers, or other countries are immune from the increasingly volatile global financial market.
First: A high amount of government spending, in which the government builds up a large debt puts a country at risk. This frequently comes as a result of populism, or government hand-outs to the people, especially before national elections.
The United States national government has an enormous national debt of eighteen trillion dollars in late 2014, which continues to increase alarmingly. One can see the numbers rolling up and up, ever up, on the debt counter on the internet. However, since the US has seigniorage of the world’s currency and can simply create dollars, this does not restrict the US economy as much as in other countries. This gives the US the ability to largely ignore the rules of the global economy which every other country has to obey to a considerable extent or face the consequences.
Second: A large current account deficit and lack of foreign exchange to finance this deficit means that a country will have to borrow foreign exchange from the IMF or private banks to finance the deficit if policy measures are not taken. The country could raise interest rates, for example, and try to attract more capital. However, this is often too little too late to stem the tide.
Third: The country runs out of foreign exchange and cannot pay its international debts. Again, since the country cannot print its own dollars, it will have to borrow dollars or Euros.
Fourth: A speculative and inflationary bubble due to good times. La Dolce Vita lasts while it lasts. But the good times do not roll on forever. Bubbles usually happen in the housing market in which people buy and speculate on property, often with mortgages. Household consumption and household debt increases.
Fifth: Political Instability. The government collapses or a series of governments collapse leading to uncertainties in the economy. A political scandal may bring down the government causing hot money to flee the country overnight and sending interest rates through the roof. The currency then sinks like a rock.
Sixth: Corruption and Crony Capitalism: This is typical of developing countries in which the top leaders help their friends and relatives dominate the economy, gain control of companies, and get richer and richer while corruption flourishes. While ruling elites often consider it their right to get themselves and their families rich at the expense of the country, the economy does not necessarily agree. The real condition of the economy is hidden, while government bureaucrats pay lip service to their masters and lie to the press. But it is harder to fool the market.
Seventh: A large inflow of foreign capital, followed by a sudden stop and then a sharp outflow of foreign capital (hot money) from the country due to an expected economic downturn or political crises. The currency comes under pressure, and the only possible solution is a devaluation of the local currency. Businesses with foreign debts may go bankrupt as their debt mushrooms.
Once the economy hits the bottom, a lot of businesses go bankrupt and a lot of people lose their jobs. Economies usually take about three years to recover from an economic crisis.
Hyman Minsky and the Minsky Model of Financial Crises:
While mainstream neoclassical economists do not believe that a crisis can be caused by the workings of the capitalist system, nevertheless, someone has to explain where they come from and why they happen. In liberal economic models, decisions made in the marketplace are rational by definition. Nevertheless, Alan Greenspan could talk about “excessive exuberance.” For radicals, on the other hand, the nature of the capitalist system tends toward crises, and indeed, the normal state of capitalism is crisis. This brings us to the model of an economic crisis proposed by Hyman Minsky. The Minsky Moment or the moment of truth.
Minsky’s Theory of Economic Crisis:
First: There is a displacement or external shock to the economy. This must be something large, such as the start of a war, a bumper crop or a crop failure, or the innovation and diffusion of a new technology. For example, the so-called dot-com revolution in the internet in the l990s.
Second: Profits increase in at least one important area, resulting in an investment boom.
Third: The expansion of credit greatly increases the money supply. Credit expands both in business and in family purchases and consumption.
Fourth: The expansion of the economy continues until it reaches a “euphoria stage.” This results in a “bubble economy.” More investors rush into the profitable areas of the economy.
Fifth: At some point in this expansion, some investors get cold feet and decide that the expansion is about to top out. They take their profits and get out of the market. They put their money in less risky investments.
Sixth: More businessmen begin to feel that the expansion is over and start to get out. This continues until it reaches a panic stage. The panic may be set off with the collapse of a major bank, such as the Lehman Brothers Bank collapse in the US, a corporate bankruptcy or other such event.
Seventh: Major Bankruptcies increase.
Eighth: Finally, the bubble bursts. Panic sets in seriously. There is a credit crunch. There is a liquidity trap with firms holding onto their cash. A recession or depression follows. Economic output drops sharply from five percent up to twenty-five percent or more.
Ninth: Eventually, the economy recovers and returns to equilibrium. The average time is around three years. Some players in the market emerge much richer. Many more lose most of what they had. Consumers’ standard of living decreases. For some, who are always poor, it does not make much difference. They are always in a financial crisis, no matter what happens in the economy.
Such a crisis is also called a “Minsky Moment.”
Mainstream Economists and the Minsky Model:
Mainstream economists reject the Minsky Model outright. They say that there can be no general model of an economic crisis. Every economic crisis has its particular features. Minsky’s model is based upon the idea that the crisis is generated by speculation in the market. Milton Friedman argued that there is no such thing as “speculation.” This sounds very much like an argument from the Austrian School.
For Minsky, on the other hand, euphoria, irrationality and financial crises are all just normal parts of capitalism. History shows that financial mania can be caused by “mob psychology” or a “herd mentality.” Charles Kindleberger, for example, agrees with Minsky that financial crises are an inherent feature of international capitalism.
An economic crisis is a complex event and it is true that they are different. However, they share a general pattern. Something serious has to happen to affect the currency. Four real world events happened as below.
The Mexican Peso Crisis (December 1994):
A new President, Ernesto Zedillo had just been elected. Carlos Salinas de Gortari was the outgoing President. Zedillo moved quickly to change economic policy.
First, Zedillo reversed the tight money controls. That is, he brought financial liberalization. Salinas’s policies while in office had strained the finances with government debt.
Second, Salinas used populism to stimulate the economy just before the election, but this policy was unsustainable due the weak economy.
Third, a low interest rate led to risky domestic loans. The quality of loans fell.
Fourth, the armed rebellion in Chiapas broke out during l994 just before the election.
Fifth, the Chiapas revolution or revolt by the poor helped cause foreign investment to drop.
Sixth. high government spending during l985-1993 had led to high inflation.
Seventh, the price of oil dropped making it more difficult for the government to pay its high debts. The current account deficit increased as it was difficult to finance the debts.
Eighth, Salinas then issued bonds to finance the debt.
Ninth, one of the presidential candidates, Luis Donaldo Colosio was assassinated in l994 just before the election.
Tenth, the current account deficit rose with dollars flowing out of the country.
On December 1, 1994, Zedillo took office. The Mexican Peso was four to a dollar. It then quickly crashed to seven to a dollar. The United States bought pesos to help out and provided Mexico with a fifty billion US dollar loan but the damage had been done. The country recovered from the crises by about 1997. This is the normal time that it takes a country to recover from a financial crisis on average.
The Asian Financial Crisis (1997):
This was the worst economic collapse since the l930s in East Asia. The countries most affected by this crisis were Thailand, Indonesia, and South Korea. However, all of the countries in Asia were affected to some degree. It was feared that it could lead to a world-wide crisis without quick action.
First, the crisis started in Thailand in July of l997. The Thai baht was allowed
to float in the market due to a lack of foreign exchange. Thailand was short of US dollars.
Second, there was a real estate bubble. There was also financial over-extension with too many loans.
Third, Thailand had a high foreign debt and was effectively bankrupt.
Fourth, the crisis then spread to all of Southeast Asia. The Japanese yen declined. Stock markets fell. Private debt rose.
Fifth, Hong Kong, Malaysia, Laos, and the Philippines were also hurt. Less affected were China, Taiwan, Singapore and Vietnam.
Sixth, the IMF launched a bail-out package of 40 billion US dollars for Thailand, South Korea and Indonesia.
Seventh, on 21 May 1998, Suharto was forced to resign as President of Indonesia after thirty years in power. There was massive crony capitalism as Suharto had divided up the economy among his close relatives.
Eighth, growth in the Philippines dropped to zero.
Ninth, by 1999, the recovery was beginning. So again, the crisis lasted about three years.
Causes of the Asian Financial Crisis:
First, there was a lot of hot money in the Asian economies. Foreign capital flowed in and then there was a sudden stop. Paul Krugman had written that there was no economic miracle in these countries. He noted that productivity was not high and the technology was mainly owned by foreign countries. But there was a high capital inflow of short-term finance due to high interest rates (arbitrage). This money was not invested in the real economy.
Second, prices had risen sharply for several years. This had created a bubble, especially in the housing market.
Third, there had been a high economic growth-rate, said to be the East Asian “economic miracle.” This growth rate was due more to the Asian developmentalist state-guided model than free-market capitalism.
Fourth, Thailand had an asset bubble in housing, stocks and other commodities.
Fifth, there was rampant crony capitalism in Malaysia and Indonesia under authoritarian regimes.
Sixth, the development money flowed to those in power under this model of crony capitalism.
Seventh, the countries were running high current account deficits. Once started, there was a domino effect as the debt defaults in one country led to defaults in other countries and affected the whole region.
Following the crisis, there was a debate about whether the crisis was caused by the new system of global financial liberalization or the strong role of the state in Asian economies. Joseph Stiglitz and Chalmers Johnson argued that the Asian model of state-led growth could not have caused the crisis. The state developmentalist model had a solid record since the l950s. No one imagined the onset of the crisis as the economies seemed to be sound. However, the governments seemed to be the logical place to put the blame. This was the view of free-market economists. Those critical of financial liberalization and leftists said that the crisis was due to allowing the free flow of global financial capital, roaming the world for short-term profits. They were inclined to argue that financial liberalization was the root cause, because this system had made the international financial system unstable and said that this unstable international financial market could bring down even strong economies under certain circumstances.
The Turkish Financial Crisis (February 2001):
First, Turkey was under an IMF structural adjustment program (SAP). The Turkish Lira was pegged to the dollar but adjustable by a crawling peg.
Second, in February 2001, the currency crashed by thirty percent, a sharp devaluation.
Third, the Turkish banking system was under political control and badly needed reform.
Fourth, there was much hot money and much corruption in the country.
Fifth, in November, before the crises, the Turkish banks experienced liquidity problems. There was a general loss of confidence in both the political and economic systems.
Sixth, the Turkish Central Bank responded by printing money massively, violating its own rules.
Seventh, some six billion US dollars flowed out of the country almost overnight. This raised the current account deficit.
Eighth, Turkey got an 11.5 billion US dollar loan from the IMF as an emergency package to bail out the sinking economy.
Ninth, meanwhile privatization was forced upon the country and the sale of state economic enterprises proceeded.
Tenth, interest rates rose sharply in early 2001.
Eleventh, on February 19, 2001, Ahmet Necder Sezer, the Turkish President, and Prime Minister Bulent Ecevit, had a fight over corruption.
Twelfth, the Turkish lira collapsed from the peg on February 21. The Turkish Lira was floated under lack of confidence in the Government.
Thirteenth, Prime Minister, Bulent Ecevit brought in Kemal Dervis, a former World Bank official, to reorganize the Turkish banking system and carry out reforms. The Turkish economy recovered after the banks were reformed and recapitalized.
In December 2013, Turkey was starting to feel some of the effects of rapid growth over the past decade, as the Fed began its tapering program, to cut back on quantitative easing. At the same time pressure was put on the currencies of India, Brazil, Russia and several other big emerging markets. When global economies are fragile, the actions of the Fed can be felt around the world at once.
Case Study: The US Financial Crisis (2007-2008):
The US financial crisis began in July 2007 when two Bear Stearns hedge funds collapsed. They had invested in mortgage-backed securities. The Fed began to flood the financial sector with hundreds of billions of dollars. By April 2009, the Fed had committed around $8.5 trillion dollars to salvaging the US financial system.
On September 18, 2008, Senator Chris Dodd announced that the US was just days away from a complete financial meltdown without a huge US Government bailout. A bill for $700 billion for the bail-out was quickly written but initially failed to pass in the US House of Representatives. The financial community was shocked at the rebuff. A few days later with sharp warnings by President George W. Bush and the Secretary of the Treasury Henry Paulson, the package for the banks was pushed through Congress. Some called it a financial coup d’ etat.
This money would buy toxic assets, that is, worthless assets, also called “toxic waste.” There was a lot of anger among the American people about the bailout and financial panic spread. This was similar to what Hyman Minsky’s theory of a crisis predicted. Stocks fell sharply. The Fed responded by pumping more dollars into the economy and the Government announced that it would buy more toxic assets. It became a buyer of last resort. The Fed would buy all commercial paper, up to $1.3 trillion, if necessary. Commercial paper is loans issued by corporations to other businesses.
Nevertheless, the system went into a liquidity trap. This happens when banks and businesses will not loan money to other banks and businesses because they do not trust that it can be paid back. They hoard money. Interest rates fell to near zero. This is what Keynes called the “propensity to hoard.” This included cash and Treasury bills. The “Financial Ice Age” had started. There was no lending between banks and businesses.
The G-7 countries announced that they would partially nationalize the banks. They would do this by buying shares and so injecting money into the banks. They expanded deposit insurance. The US Government would guarantee $1.5 trillion debt to be issued by banks. The cost of the bailout package came to $2.5 trillion by the time of the Lehman Brothers Bank Collapse.
Funds were also committed to bail out Fannie Mae, Freddie Mac, the Wall Street Firm Bear Sterns and American International Group (AIG). The total bailout at that point was estimated at $5.1 trillion.
The contraction of the economy continued. Auto companies, Ford, Chrysler and General Motors, got a $25 billion bailout, with more low interest loans promised later. Some 600,000 to 700,000 jobs were lost in December 2008 and January 2009 as the crises began to hit the real economy.
There were two major theories about the crisis. First is the Milton Friedman, Ben Bernanke, monetarist theory, that it was a liquidity crisis. Secondly, the Monthly Review School argued that it was a structural crisis of capitalism.
According to monetarist theory, the crisis could be solved by just pouring a lot more money into the banks and the financial sector. Ben Bernanke, who became the Fed Chair, and was a monetarist, had said that one could just fly over the country and drop money from a helicopter to solve the crisis. After this he was called “helicopter Ben.”
The second theory from Monthly Review would mean that financial sector debt would have to be squeezed out of the system before the markets could recover and get back to production in the real economy. It was a structural crisis.
By the end of 2008, most banks were insolvent. They could not pay their debts because all their assets had been wiped out by the declining values of the loans which they owned. It was clear that many of these loans could not be paid back. Several bank mergers quickly took place. JP Morgan Chase bought Washington Mutual and Bear Stearns. Bank of America bought Country Wide and Merrill Lynch. Wells Fargo bought Wachovia Bank.
Banks became more monopolistic and the US Government purchased more shares to help liquidate the loans and get the banks back to solvency. At the same time, people lost jobs and were unable to pay their debts.
The Great Depression and the Lender of Last resort:
The confidence in the system is underwritten by the Government, as the “lender of last resort.”
For Bernanke, it was just a liquidity crisis which could be fixed by pumping massive money into the economy. You just fly over and drop money (helicopter Ben). Bernanke had argued that economists had figured out how to keep a depression from ever happening again. He thought the Federal Reserve could always reflate the economy by pumping in more dollars. When the interest rate gets down to near zero, the Fed can buy government securities to pump money into the economy. This was quantitative easing which is just another name for printing dollars.
So Bernanke argued that the Fed only had to look at monetary factors and not at the real economy. Nothing was done until the housing bubble burst in 2007. Then money was pumped into the economy massively.
The Financial explosion and implosion:
The are two parts to the economy: The real economy (base) and the financial superstructure. The US economy had started to generate most of its profits from the financial superstructure, rather than the underlying real economy. The Monthly Review School (Harry Magdoff and Paul Sweezy) had always argued that the normal state of the underlying capitalist economy was stagnation. They argued that the root problem when the bubble burst was not the mortgage problem but the real economy.
Most profits were being made in speculation in the financial sector of the economy with ever expanding debt. This increased from 1.5 trillion in 1970 to almost 48 trillion in 2007. And private debt had skyrocketed relative to national income from the l960s. This stimulated the economy, boosted economic growth, and provided large financial profits, but was not sustainable. There was a large gap between the financial superstructure of the economy and the underlying real economy, where surplus value is generated. The profit from speculation in the superstructure is just an advance on the exploitation of surplus value in future, but the gap had become too large.
The US financial system was a giant casino with leveraging debts thirty to one. It was bound to collapse unless the system kept expanding indefinitely, which could never happen. This was a contradiction associated with speculative bubbles.
When the bubble finally burst, the economy could not recover until the debt was liquidated, written off, or more likely taken over by the tax payers. It became a “debt overhang.” However, some economists had started to believe in the theory of the “New Economy” and thought that with enough financial management tools such a crisis could be prevented from ever happening again. Alan Greenspan, the former Fed Chief, said that he was absolutely shocked that the bank crises happened so quickly.
Paul Sweeney and Harry Mag doff in their book, Monopoly Capital, had pointed out that the US economy could absorb excess capital through government spending on the military, advertising, new innovations and so on and this would promote economic growth. However, these enterprises were never enough to get the economy out of the essential problem of stagnation. The normal state of a capitalist economy, in their view is stagnation. Financialization of the economy became necessary to provide the necessary growth. However, this was speculative and ran the risk of financial crisis and collapse.
The real stimulus to demand in the US economy, in this view, was the growth of debt. Credit cards, mortgages, student loans and so on kept piling up higher and higher to keep the economy going. Government spending, national, state and local and so on, was also increasingly based on debt. This was going on in other economies as well.
According to the Monthly Review School, some $1.2 trillion of excess profits had been made by financial speculation. They argued that this must be squeezed out of the system by “mean reversion.” The long-term trend in financial markets must return to a mean projection or trend line of normal profit, according to this theory. This $1.2 trillion of excess profits would have to be wiped out before the system returned to the long term trend in growth.
The system would need to undergo a major economic downturn to return to the normal growth.
The attempt to solve the normal stagnation problem by pumping up paper profits in the financial sector had failed.
After World War II, the US was in a special situation and was able to stimulate the economy. US prosperity benefited from savings from the war period, automobilization, people moving to suburbia, increasing consumption, housing developments, the interstate highway system, the glass, steel and rubber industries, the rebuilding of the Japanese and European economies, the Cold War arms race, advertising, TV expansion, insurance, and the US dollar. This was the “golden age” of American capitalism. However, this ended with the recovery of Japan, East Asia and Europe. US GDP fell from about six percent during the war to 2.6 percent. With economic stagnation, came financialization and neoliberalism. It was financial Keynesianism and produced asset bubbles which were subject to bursting.
A new class war set in. Real wages fell as profits rose largely in the financial sector. Labor costs were pushed down. Wages peaked in the US in l972 at about $9 dollars an hour. They had fallen to $8.24 in 2006. There was a massive redistribution of income upwards and greater inequality. This increased during the Reagan years in the l980s. Those at the top got richer while most got poorer.
But household consumption rose, not through greater wages, but as a result in the rise in equity values in houses. But this also meant that household debt increased on new mortgages from forty percent of GDP in l960 to 100 percent of GDP by the l990s. People borrowed money on the value of their house in order to keep consuming. They were told that their house was a bank and that they owned their own bank. An increasing number of house owners owed more on their house than it was worth. They were “under water.”
At the same time, there was less investment in the real economy and so less capital formation. In the dot-com revolution in the l990s, this was not seen as important. Investment was expanding through speculative financial instruments. More and more, profits had nothing to do with production as most production was sent offshore to Mexico and China. Stagnation in the domestic economy was certain to remain.
The economic slow-down in the US spread the crisis to the rest of the world, first to Europe. There would be slow growth and high unemployment around the world as a result of the US crisis. The economy of Iceland melted down where the banks had invested in speculation abroad under a right-wing government for years. Iceland refused to pay and defaulted on the loan.
The cost of bailing out the rich was put on the backs of the poor. People were angry. Rather than to create jobs, the government used monetarism or quantitative easing. This kept the economy afloat, but did not serve to create jobs as was done after the great depression in the l930s. The government could have spent up to 13.5 percent of GDP to put people back to work.
Instead, the monetarist solution was to return to business as usual and the same kind of financial speculative system. The critics argued that it was not a sustainable system and just created more wealth for the rich and inequality.
The Dynamics of the Mortgage Crisis in the US: Monopoly Finance Capitalism
The housing bubble was crucial to US capitalism because this was providing much of the income for spending in the last few years, with job creation weak. Higher interest rates could generate stagnation, leading to defaults and foreclosures. There was a rapid growth of hedge funds and credit derivatives. The panic spread after the collapse of the sub-prime mortgage market in July 2007 and all sectors were affected. Adjustable rate mortgages, commercial paper (unsecured short-term corporate debt), insured bonds, commercial mortgages, corporate bonds, auto loans, credit card debt, student loans are all forms of money that are traded on the markets on an international scale. This financial unwinding soon reached the real economy resulting in falling employment, weakening consumption and investment, and decreasing production and profit.
By February 28, 2008 the US growth rate had fallen to zero. The recession had begun.
Over the last four decades, there had been a shift from production under Fordism to finance with a rapid growth in financial profit.
The Five Phases of the bubble and the Minksy Model:
The housing bubble expanded to trigger the crisis. Capital flowed into the housing market causing hyper-speculation. The five phases include a novel offering, credit expansion, speculative mania, distress, and crash/panic.
First, the novel offering was the “collateralized debt obligation” (CDO). The collateral is the house for which the mortgage loan was made. The cash from these loans, after pooling them, was a basis for more loans to generate “mortgage backed securities.” These mortgage backed securities were repackaged in the form of “Collateralized Mortgage Obligations (CMO). They were packaged so that they were a mix of low-risk, middle-risk and high-risk (subprime) mortgages. The ones with more risk were “junk bonds.” They were rated according to risk of default. Some were investment grade. And banks were allowed to invest in them. Mixing sub-prime with other mortgages would make almost all of them into “safe bets,” theoretically. They were also insured by bond agencies. Some were even AAA rated. All this vastly expanded the market for mortgage lending. So people with poor credit histories could get mortgage loans.
These new securities could be sold through new global financial markets. Structured Investment Vehicles (SIVs) were set up to hold CDOs .These were virtual banks. They drew on the commercial paper market for short term funds to buy the mortgages. Short-term funds were borrowed to invest in long-term securities. Credit default swaps were made with banks. This meant that the SIVs made quarterly payments to banks, like Bank of America. In return banks promised to make a large payment if the SIVs found their assets declining and their credit drying up. This would prevent them from being forced into default. This left the banks exposed to risks that they had tried to transfer elsewhere.
The second phase was credit expansion. Credit is required to feed the asset bubble. The Fed lowered the interest rate to one percent in June 2003, so interest was very low. Mortgages expanded. House prices increased. But jobs paid low salaries. Many loans for houses were adjustable rate mortgages. Low “teaser” interest rates were given to begin with that would go up in three to five years. This made the homes affordable as long as one’s income held out and increased. People believed house prices would continue to rise. A huge rise from $56 billion in loans in 2000 mushroomed to $508 billion in 2005.
The third phase is speculative mania. In this phase there is a rapid rise in debt and a rapid decrease in its quality. It is assumed that house prices will continue to rise. It is Ponzi finance or hyper-speculation. The debt is not based on income streams but merely on what the value of the assets may be in future. CDOs increasingly took this toxic form. Real estate speculators got into the business. Mortgages were used for consumption. Mortgage borrowing increased by $1.1 trillion between October 2005 and December 2005. Total mortgage debt went up to $8.6 trillion, which was equal to seventy percent of the US GDP.
The fourth phase is distress. Something caused the speculative bubble to be pricked. In 2006, interest rates rose. Housing prices declined in California, Arizona and Florida. Mortgage payments ratcheted up at the same time. Credit debt swaps increased globally by forty-nine percent, to cover $42.5 trillion in debt, in the first half of 2007.
The fifth phase is crash and panic. There was a rapid selling off of assets in a “flight to quality.” Investors wanted liquidity. First two Bear-Stearns hedge funds collapsed in July 2007. They held $10 billion in mortgage backed securities. They lost almost all their value. Banks in Europe and Asia were also exposed to toxic assets. A credit crunch began as banks did not know the extent of their exposure. The commercial paper market was hit, which was the source of funds for the SIVs.
September 2007, Northern Rock Bank failed and was bailed out. There was a run on the bank.
Bond insurers began to fail because they underwrote the credit default swaps on mortgage-backed securities. Financial panic spread. No one could be sure what investments were toxic.
There was a stampede into US Treasury bills. In January 2008, the system had reached the panic stage. The Fed poured money into the system. Consumer spending was hit. The governments in the US and Europe were left to bail the capitalists out.
It was a crisis of the stagnation of capitalism, according to Monthly Review. In the US, capacity utilization was around eighty-five percent in the l960s. It fell to eighty percent between l972 and 2007. Big companies had a “mountain of cash,” at least $600 billion, but investment declined. So the capital went into the financial sector. The FIRE sector included finance, insurance, and real estate. This is the non-productive sector or the economy. The main stimulus to the economy, other than finance, had been military spending.
It was stagnation that led the financialization of the economy. On the other hand, others argued that it was the other way around. Financialization had led to stagnation by crowding out other investments. However, this theory is rejected by the Monthly Review School. They said there were real opportunities for investment outside the financial sector. It is a structural crisis of capitalism itself which is the real problem.
Recent Trends in International Financial Flows:
US Quantitative Easing by the Fed: Quantitative Easing is another name for printing money and increasing the money supply in the economy. Some of this money finds its way into emerging economies and boosts economic growth. However, these financial flows can come to a sudden stop and then flow out, leading to a financial crisis.
However, the US Government only gets the money from the Fed by borrowing it, that is, by buying bonds. The Fed, the national bank of the United States, which creates dollars, is not owned by the people but by the private banks. It costs about seven cents to make every US dollar.
Financial Flows in percentage of GDP in Advance Countries: In the 1980s financial flows were five percent of advanced country GDP. This increased to twenty-five percent in 2008. By 2010, financial flows declined to ten percent of advanced country GDP due to the US financial crisis.
Financial flows in Emerging Countries: In the l980s, financial flows were two and a half percent of the GDP of emerging countries. In 2008, financial flows increased to twelve percent, but fell back to seven and a half percent in 2010 due to the US economic crisis.
In emerging market countries, large inflows of foreign capital support large housing markets, big shopping centers, and so on. It tends to make government borrowing easy. Also consumer credit is increased. It also encourages corporate leveraging. These inflows can greatly increase when the Fed and the European Central Bank are engaged in quantitative easing programs such as the period from 2008 up to 2014.
Financial Outflows from Developing Countries: In 2000 financial outflows from developing countries was some 295 billion US dollars. In 2013, this increased to 1800 billion US dollars.
Forex Trading: The volume of Forex trading is about 100 times greater than international trade flows today. This means that the rate of currency exchange in global markets is largely determined by currency flows. Daily Forex Trading in 2014 was 5.3 trillion US dollars per day or 1825 trillion US dollars per year. Trade Flows were 18.3 trillion US dollars per year. These figures were expected to increase.
Forex Trading by Countries in 2013: In the USA, forex trading was 860 Billion US dollars per day. In the UK forex trading was two trillion US dollars per day. In Japan forex trading was 283 Billion US dollars per day. Clearly, London lives up to its reputation as the money-laundering capital of the world.
Global Foreign Direct Investment in 2013: Foreign direct investment was between 1.1 trillion and 1.5 trillion US dollars per year. Some 700 billion US dollars went to developing economies. Some 561 billion US dollars went to developed economies.
Derivatives in the Global Economy: As of June 2007 there were 516 trillion US dollars in derivatives. Much of this value was wiped out, however, by the 2008 US financial crisis.
US Quantitative Easing (printing money): The Fed has been pumping some 85 billion dollars per month into the US economy from September 2012 through 2013. This is 1.02 trillion dollars per year. This followed other quantitative easing periods to get the economy back to health.
European Quantitative Easing (QE): The European Central Bank created some 1.5 trillion dollars in 2013. (LTRO Liquidity Injection Policy)
Regulating the International Financial System:
A number of scholars have stated that the international financial system is the weakest link in the global financial system. Among these are Charles Kindleberger, Susan Strange and James Tobin. Various measures have been proposed to strengthen the system.
The Tobin Tax: James Tobin proposed that a small tax be placed upon international financial flows. This would provide a fund which could be used to bail out economies which experienced financial crises. The tax has never been implemented, however.
George Soros is a financial speculator who made huge profits on speculating on foreign currencies. He wanted a “lender of last resort.” A lender of last resort is a source of loans for a country which experiences a financial crisis. People like George Soros can do a lot to help them along. So someone should come along and pick up the pieces of the economy after George and the other money traders have taken their profits and left the mess behind.
The IMF has traditionally played the role of lender of last resort. However, even the IMF may not be capable of dealing with the need for funds in the contemporary global economy. In the case of the United States economic crises in 2008, it would have been impossible for the IMF to come up with the funds to bail out the US. This had to fall to the US taxpayers, and quantitative easing by the Fed. The US Government bailout at the end of 2008 was more than 800 billion dollars to prop up the banks. The total package was much greater. The US Government bought a lot of essentially worthless paper assets to keep banks and other companies from bankruptcy, which were considered “too big to fail.” But at the same time, several million families lost their homes in foreclosures of their mortgages. They were too small to save.
In the case of countries in the European Union, such as Greece, Spain and Portugal, a combination of funding has come from the IMF and the largest banks of Europe. Sometimes the poor just have to make sacrifices so that the rich can go on having their easy and plush lifestyle. At least in today’s global economy.
A lender of last resort raises the issue of “moral hazard.” The argument is that the existence of a lender of last resort can result in a moral hazard. This is because if a country knows that it can be bailed out in the event of a financial crisis, it will follow risky policies. However, the danger to the global economy of the collapse of a large country or area means that in practice, countries must be bailed out to stabilize the system. There is great fear of financial contagion.
Economists do not agree on what can be done. It reminds one of the old joke: “If one laid all economists end to end, they would all be pointing in different directions.”
Financial Crises and Austerity:
Under the neoliberal policies of today’s global political economy, financial crises are being dealt with by imposing austerity on countries. For neo-Keynesians, like Paul Krugman, this is exactly the wrong medicine and is likely to kill the patient. Krugman has blamed much of the volatility in the global political economy upon these wrong policies in Western countries.
A pattern has emerged in the global economy of swinging from bubbles to depression. Most of the blame is not in emerging market countries like India, Russia, Hungary, South Africa and Turkey. The austerity policies in Europe and America being urged by extreme political conservatives, depresses economic growth in Western countries. There is too much savings and not enough investment to stimulate growth in the world economy. Excess capital flows to emerging economies to take advantage of higher interest rates, but when there is a sudden stop, an economic crisis is triggered.
Thorstein Veblen would surely have been amused. Since the l970s, the bankers and money traders have greatly increased their profits in the global financial sector by destabilizing the global financial system. This is exactly what he predicted as the role of businessmen. When they wreck the economy it opens up opportunities to increase their profits.
Following formal rational economic models, economists generally believe that it is just the opposite. That the new system of financial liberalization ensures that capital is used in the most efficient way. When there is an economic crisis, however, the big firms get bailed out while it is the common people who lose their savings, pay higher for everything they need to live, and lose their jobs.
In such a situation, emerging countries owe it to their citizens to take some precautions to curb speculation in the financial sector for profits. Much of these profits are secreted away in Swiss bank accounts or offshore tax havens. All of this goes under the rubric of corporate ethics.
The 1970s were marked by a revolution in the international financial system. Financial flows were liberalized, greatly increasing the volatility in the global political economy. Massive financial flows have come to largely control the exchange rates of big emerging market countries and have contributed to the risk of financial crises in these countries. This development reflects the extension of the financialization of the US economy globally. Recent financial crises include the Mexican Peso Crisis, the Asian Financial Crisis, and the Turkish Economic Crisis. The largest and most serious financial crisis was the 2007-2008 US financial crisis which spread to Europe and still affected the global economy in 2014.
Monetarists believe that the US financial crisis was the result of a liquidity crisis which could have easily been remedied by an appropriate Fed monetary policy. Marxists scholars at the Monthly Review School in New York, on the other hand, argued that the crisis was caused by a structural crisis of capitalism. They argue that it was due to the tendency of mature capitalist economies to fall into economic stagnation.
The Minsky model of an economic crisis is based upon the observation that a speculative bubble can emerge leading to an economic crisis. This is particularly true in the financial sector of the economy. The United States and Europe have dealt with the financial crises through monetarist policies of quantitative easing and austerity, rather than Keynesian job creation programs. This seems to be the wrong way to solve the crisis, in terms of global economic growth. This policy has been criticized by neo-Keynesian economists such as Paul Krugman and Joseph Stiglitz. World economic growth slowed considerably to only 2.1 percent in 2012.
Financial Instability Theory
East Asian Financial Crises
Mexican Financial Crises
Turkish Financial Crises
New International Financial Architecture
Lender of Last Resort
Basle Accord (1988)
The Federal Reserve
Ben Bernanke (Fed Reserve Chairman)
Henry Paulson (former Treasury Secretary)
Buyer of last resort
Lender of Last Resort
“Propensity to Hoard”
“Financial Ice Age”
Financial instability hypothesis
The New Economy
The Stagnation Problem
Collateralized Debt Obligation (CDO)
Collateralized Mortgage Obligation (CMO)
Structural Adjustment Vehicle (SIV)