Wednesday, 1 October 2008

Fundamental driving forces of the financial crisis

Introductory note

Socialist Economic Bulletin is reproducing three articles on the long term background to the current financial crisis which appeared on the blog Key Trends in the World Economy. This blog is published by John Ross, Ken Livingstone's Director of Economic and Business Policy when the latter was Mayor of London. The views expressed in these articles are, however, the personal ones of John Ross and do not necessarily represent the views of Socialist Economic Bulletin.

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It is superfluous to note on this blog that the world economy is passing through the most severe financial crisis since 1929.[1] Its results are also beginning to be well understood: the era of increasing deregulation has ended and instead increased, in the US very large scale, state intervention in the economy has begun.[2]
But what type of crisis is this - which greatly affects what its eventual outcome will be?
The most trivially superficial explanation, put forward in tabloid newspapers and demagogic political speeches, is that this is an extremely severe short term convulsion caused by the activities of ‘financial spivs’ and ‘short sellers’– modern embodiments of the ‘gnomes of Zurich’ denounced by British Prime Minister Harold Wilson in the 1960s, Slightly less superficially it is ascribed to subjective, widespread, miscalculation by financial institutions.[3] A related view is that the fundamental factor is psychology.[4] Therefore, there is a widely asserted view that the key issue is ‘confidence' or 'lack of confidence’.
If any of the above were true then, although the present financial convulsion is severe, the adjustments that will follow will eventually be relatively minor. Once current psychology is reversed, that is ‘confidence is restored’, there can be a return to something approximating the previous situation – doubtless with some individual changes.
Such analyses are false. The present financial crisis is not rooted in psychology or subjective mistakes. It is rooted in long term economic trends. Its roots are therefore objective not subjective. Psychology is not driving the objective economic forces but following them.
The unfolding of the financial crisis does, however, show the importance of considering long term trends, and underlying developments, rather than merely considering short term shifts or individual facts taken out of context - as occurs in many newspaper commentaries. Misunderstanding of the preceding period, through failure to consider the overall situation, inevitably led to confusion regarding present events.
The outcomes, and conclusions regarding the real driving forces of the present financial crisis, will be considered at the end of this article. First, however, the decisive data on the situation will be set out.
The most fundamental cause driving the present financial crisis was dealt with in a previous post on this blog - 'Why Asia will continue to grow more rapidly than the US or Europe'. This showed that the US now lags far behind the key Asian economies in the proportion of its economy which is invested - with a consequent continuing decline in the international competitiveness of the US economy.
This trend can be seen in Figure 1 - which is a simplified form of the graph in the previous post. It shows the investment levels (gross domestic fixed capital formation) as a proportion of GDP in the US, China and India. The US invests only 18-20 percent of its GDP whereas India invests over 30 percent and China more than 40 per cent. Similar, if less striking, graphs would show the same pattern for other key Asian economies. The result is China’s economy is growing at 9-11 percent a year, India’s at 7-9 per cent a year, and the US at only 3 percent a year.

Figure 1

Given this US lag in investment, which is a key factor in competitiveness, the US economy, at any given exchange rate, becomes progressively less competitive over time. Consequently, given this decreasing underlying competitiveness, as long as the US does not raise its investment levels to that of other economies the only way for it to remain competitive is to steadily lower its exchange rate – that is to progressively devalue the dollar.
This declining competitiveness of the US economy is illustrated clearly in Figure 2, showing the US balance of payments. That the US runs a large balance of payments deficit is well known, but this graph shows the phases in the unfolding of that process.

Figure 2

The US balance of payments first began to slide into sharp deficit in the early 1980s - the deficit initially reaching over 3 per cent of GDP by the mid-1980s
There was a short lived recovery in the early 1990s - due to dollar devaluation, recession at the beginning of that decade, and a large one off payment from the Gulf states to finance the first Gulf war.
This short recovery was followed by an even greater US balance of payments deficit after 1991 - which reached a peak of well over 6 per cent of GDP, or over well $700 billion a year, by 2006.
To show this development over a longer period Figure 3 shows net US ‘lending’ to the rest of the world since 1956 – a negative number showing US borrowing from the rest of the world. The deterioration of the competitiveness of the US economy is evident from these trends.

Figure 3

Given that the low US level of investment means the only fundamental mechanism by which it can remain competitive is dollar devaluation therefore Figure 4 shows the long term exchange rate of the dollar against two of the world's three most important non-US currencies, the euro and the yen - comparisons over the same period with the third, the yuan, are not meaningful as until the early 1980s China had an artificially set exchange rate which was not aimed at participation in international trade.

Figure 4

Three clear periods of developments in the US exchange rate are evident.
- From the immediate post-war period to the early 1970s the US maintained fixed exchange rates under the Bretton Woods currency system.
- From 1973 until the mid-1980s, via sharp short term fluctuations, a substantial dollar devaluation took place.
- From the mid 1980s onwards, while there were considerable short term fluctuations, and formally a floating exchange rate system operated, in fact the long term trend of the dollar’s exchange rate was stable.
The worsening US balance of payments situation, already shown in Figure 2, was an inevitable result of the the two circumstances which operated after the mid-1980s. The combination of
a deteriorating competitiveness of the US due to its low investment rate
a stable dollar exchange rate which prevented competitiveness being maintained by devaluation
necessarily meant an increasing movement into deficit of the US balance of payments - precisely as shown in Figure 2. In otherwords the dollar became progressively overvalued compared to the underlying competitiveness of the US economy.
The means whereby this dollar exchange rate remained stable, despite the worsening balance of payments deficit and the fact that the exchange rate was not formally fixed, is shown in Figure 5. Net foreign purchases of US debt instruments, Treasury Bonds and others, rose from around zero per cent of GDP in the early 1980s to 5.6 per cent of GDP in 2007 or $770 billion. The large inflow of investment in US debt instruments counterbalanced the deteriorating current exchange deficit to maintain a stable dollar exchange rate.

Figure 5

It is, however, impossible to cheat underlying economic forces. The history of all economies shows that attempts to artificially maintain a high exchange rate against the pressure of underlying economic forces will eventually fail. In short, at some point, there would inevitably be a dollar devaluation.
The consequences of an overvalued dollar for asset values denominated in dollars are also clear. The values of assets held in overvalued dollars are themselves necessarily overvalued in real international terms. There would, therefore, eventually be a revaluation of such assets downwards to their real, that is lower, values. As that downward revaluation takes place it will erode or destroy the balance sheet of the institutions holding such assets – this is the process which is at present occurring, unleashing the wave of bankruptcy of US financial institutions.
As the dollar devalues, and assets decline towards their real competitive values, two other processes occur.
Foreign holders of dollar assets suffer losses – given that last year alone such inflows, as noted, amounted to $770 billion in US debt instruments any such losses would be large. Japan is estimated to hold $860 billion in US debt instruments, including Treasury Bonds and $75 billion in debt issued previously by the recently nationalised US mortgage institutions Fannie May and Freddie Mac. China is estimated to hold large quantities of US Treasury Bonds and up to $400 billion in Fannie Mae and Freddie Mac debt.
Given the decline in the value of US assets, a political struggle breaks out between different groups in the US population over who will bear the cost of such a fall.
Given the preceeding overvaluation of the dollar it is inevitable that such shifts should take place. In essence the current financial crisis in the US is a classic one of the attempt to maintain an overvalued exchange rate - the type of crisis which affected Mexico in 1982, Russia in 1998, or Argentina in 2001. In each of these cases the inevitable collapse of the attempt to maintain an overvalued currency wrought havoc on the financial institutions of the country concerned. In the case of the US the fact that its economy is on a much larger scale, and plays a pivotal role in the global economy, makes the consequences of such a crisis far more severe.
Why, however, If the crisis is of a rather classical form is there confusion over its driving forces - of the type outlined at the beginning of this article?
The confusion has arisen because a number of commentators in the preceeding period, instead of considering fundamentals and overall trends, took individual facts out of context and created a false ‘narrative’ regarding developments. This perspective was that the US economy was becoming more competitive - to the point where it had created a ‘new economy’. This false perspective was rationalised by looking at a few individual sectors, notably high technology, in which the US is indeed highly competitive. But, as shown in the balance of payments figures, overall the US economy was becoming less, not more, competitive.
The financial crisis is therefore not rooted in psychology nor in short term developments. It is rooted in objective economic processes operating over long periods. The outcome and unfolding of this crisis will, however, be determined by political factors.
The interrelation of these economic and political elements will be looked at in a future post. But the fundamental factors in the situation are clear and flow from the above trends.
If the US were to seek to achieve a level of investment to match its Asian rivals this would, in the short term, due to the huge transfer of resources from consumption to investment that would be required, unleash a wave of popular discontent in the US that would destabilise the political situation - for that reason it is highly unlikely to occur in the short term. The only other way to restore competitiveness in the short term, that is dollar devaluation, would cause radical financial destabilisation as the value of dollar assets declines - destroying the balance sheets of financial institutions holding such assets.Either course will produce strong pressure on the living standards of the US population and therefore have major political impact in the US.

This article was originally published as 'Fundamental driving forces of the financial crisis' on Key Trends in the World Economy

[1] For the New York Times: ‘The nation is gripped by the worst financial crisis since the Great Depression.’ For the Wall Street Journal it is ‘Black September' which the papercharacerised simply as 'the worst financial crisis since the 1930s'. The Times characterised the US as suffering from: ‘the cataclysmic fall-out from the country’s worst financial crisis since the Great Depression of the 1930s.’ For the Guardian it was: ‘the most traumatic week on Wall Street since the Great Depression’ For Robert Peston of the BBC: ‘The US Government... admitted that the financial system was on the verge of total meltdown.’
Wall Street Journal gave a particularly graphic account of the events of 19 September: ‘When government officials surveyed the flailing American financial system this week, they didn't see only a collapsed investment bank or the surrender of a giant insurance firm. They saw the circulatory system of the U.S. economy -- credit markets -- starting to fail.
‘Huddled in his office Wednesday with top advisers, Treasury Secretary Henry Paulson watched his financial-data terminal with alarm as one market after another began go haywire. Investors were fleeing money-market mutual funds, long considered ultra-safe. The market froze for the short-term loans that banks rely on to fund their day-to-day business. Without such mechanisms, the economy would grind to a halt. Companies would be unable to fund their daily operations. Soon, consumers would panic...
‘One day later, Mr. Paulson and Federal Reserve Chairman Ben Bernanke sped to Congress to seek approval for the biggest government intervention in financial markets since the 1930s. In a private meeting with lawmakers, according to a person present, one asked what would happen if the bill failed.
"If it doesn't pass, then heaven help us all," responded Mr. Paulson, according to several people familiar with the matter.’
Similarly: America was “literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally,” Senator Christopher Dodd, Democrat chairman of the Banking, Housing and Urban Affairs Committee reported after the meeting.’
[2] As the
Wall Street Journal put it: ‘In Turmoil, Capitalism in U.S. Sets New Course’. More precisely: ‘the biggest financial shock since the Great Depression, is prompting a Republican Treasury secretary and Federal Reserve chairman to devise the most muscular government intervention in the economy since the Great Depression in an effort to prevent the economic devastation of the Great Depression.’
'In March, the Federal Reserve shattered a half-century of tradition in which it had lent money only to banks whose deposits were insured by the government. Declaring circumstances to be "unusual and exigent," as required by a little-used statute, it lent to investment bank Bear Stearns and eventually risked $29 billion of taxpayer money to induce
J.P. Morgan Chase to buy Bear. It seemed a very big deal at the time.
‘But in the past two weeks, the U.S. government, keeper of the flame of free markets and private enterprise, has:
‘- nationalized the two engines of the U.S. mortgage industry, Fannie Mae and Freddie Mac, and flooded the mortgage market with taxpayer funds to keep it going;
‘- crafted a deal to seize the nation's largest insurer,
American International GroupInc., fired its chief executive and moved to sell it off in pieces.
‘- extended government insurance beyond bank deposits to $3.4 trillion in money-market mutual funds for a year;
‘- banned, for 799 financial stocks, a practice at the heart of stock trading, the short-selling in which investors seek to profit from falling stock prices.
‘- allowed or encouraged the collapse or sale of two of the four remaining, free-standing investment banks, Lehman Brothers and Merrill Lynch;
‘- asked Congress by next week to agree to stick taxpayers with hundreds of billions of dollars of illiquid assets from financial institutions so those institutions can raise capital and resume lending.
‘It was less than a week ago that Mr. Paulson appeared to draw a line at government bailouts, rebuffing Lehman's plea for a Bear Stearns-like rescue and allowing the investment bank to collapse into bankruptcy. "The national commitment to the free market lasted one day," Barney Frank, the Massachusetts Democrat who chairs the House Financial Services Committee, quipped earlier this week. That one day was Monday, Sept. 15. The day before the government rejected Lehman's cry for help; the day after it seized AIG.’
Financial Times stated the US government: ‘envisage[s] the most extensive peacetime expansion of the role of government in the financial system since the Great Depression and appeared to many to mark the end of an era of Reaganite deregulation.’
[3] The BBC's respected business editor,
Robert Peston, for example stated: ‘an entire generation of banking executives had behaved wholly irresponsibly in their lending practices for years’.
[4] Robert Peston, for example, suggesting
that what we now have is ‘a stock market that is bereft of reason and is being driven almost purely by hysteria and momentum.’

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