The crisis is due to both government and capitalist failure.
Dr Anand VP Gurumoorthy
The financial crisis that originated in the US in 2007-08 spread to other parts of the world culminating in the current European crisis which is threatening to destroy the European Union and demolish the Euro.
In my opinion, the 2008 crisis is 70 per cent a failure of government policies and 30 per cent a failure of Wall Street capitalists. In what follows I explain why.
The 2008 crisis has its origins in policies framed in the mid-1980s when Republican president Ronald Reagan assumed power. Now, I don’t have any bias towards Democrats or towards Republicans. Both have failed to curb big government spending. Democrats in power raise taxes to fund governmental spending thus causing hardships to their citizens. Republicans cut taxes but borrow massively from other countries thus increasing the national debt and passing on the hardships to future generations. And this is what the Reagan government did. It was not the deregulated capitalism of the Reagan government or the Greenspan regime that caused the bull rally of the 1980s and 1990s in the US. It was the massive borrowing that caused the bull rally. The US government in turn encouraged the banks and general public to spend more by giving extremely low interest loans. At the same time, the US Congress made motions to promote home ownership among the US public. “A home for every American” was the slogan.
Faced with the massive influx of (borrowed) capital, the banks started giving easy loans to the public. Very soon, due to extreme competition in the mortgage market, the lending penetrated into subprime territory. Subprime loans were risky loans given to the lower strata of the society. The banks were so lax that they did not check whether the loan applicants were creditworthy or would be able to repay their loans. An example is the No Income No Asset (NINA) loans, which were given to Americans without documentation. Some Americans with no resources boasted of owning four to five houses on mortgage. Another twist was the Adjusted Rate Mortgage (ARM) loans in which the unwary customers were seduced by low initial interest rates and which later on escalated to high levels. As more and more Americans invested in houses, and house purchases increased, a housing bubble formed with the rates of real estate shooting sky high.
In parallel with this was the business of mortgage securitisation. Traditionally, when a bank issues a loan, the loan stays on with the bank. Some investment banks had the bright idea of converting the subprime loans into securities which were then sliced and diced to form derivatives called Collateralised Debt Obligations (CDOs). These CDOs were surprisingly highly rated by leading rating agencies like Standard & Poor’s and lapped up by the markets. Ostensibly the process of mortgage securitisation eliminated risk but actually risk was compounded. (The process of risk heightened with the advent of destructive inventions like synthetic CDOs which “mimic” the performance of real CDOs but without backing of mortgages.In my opinion, these destructive inventions were desperate attempts by the Americans to tap into the savings of others after having exhausted their own). Owing to the globalised nature of the world economy, the CDOs spread to various parts of the world and several countries got exposed to the risky subprime loans doled out in the US. The risk was even worsened by the huge leverage (borrowings) that US banks employed in selling the toxic securities. In some investment banks the debt ratio was as high as 30:1. Why did the banks take such risks? Two reasons strike me as plausible: (a) The senior management had a lot to gain in terms of the large bonus which were calculated as a percentage of the returns, and (b) In the back of the minds, the banks were certain that the government would step in to rescue them if anything untoward happened (This was seen in the case of the bailout of the hedge fund Long Term Capital Management in 1998). This is why I maintain that the 2008 crisis was due to both government failure and capitalist failure. To paraphrase Peter Schiff, the entire Wall Street was drunk and the US government supplied the alcohol. This does not mean that the Wall Street capitalists were not to blame. They should not have taken intemperate decisions in face of such temptations.
As was inevitable, the housing bubble burst in mid-2000s. This was not wholly unpredicted. People like Robert Schiller and Peter Schiff had forecasted the real estate crash but were scoffed at. As the real estate crash occurred, housing rates came down drastically. Homeowners found that they were paying more towards their loans than their houses which were worth. They began to default. In 2006-07, the rate of defaults escalated to the range of 300,000 defaults per month. The banks were left holding empty houses which they could not sell and the housing rates plummeted even further.
Bear Sterns was the first investment bank to go under. It had such a large amount of toxic mortgage securities that it could not meet margin calls. The US government stepped in to bail out Bear Sterns. This led to countrywide protests over the anti-capitalistic and anti-free-market nature of US government actions. So when Lehmann Brothers, another bearer of toxic securities (to the tune of over $100 billion), tottered in 2007, the US government refused to step in. But when AIG, the giant insurance company, was found having a huge hole in its balance sheet due to toxic securities whose value had plummeted, the government could not sit idle. AIG effectively had branched out throughout the world and insured most dealings of most American firms and individuals. If AIG fell, next would be Merrill Lynch, then Morgan Stanley, then Goldman Sachs and then possibly the iconic American company General Electric. It would lead to the collapse of the American economy, so the Federal Reserve and Treasury got worried. To cut a long story short, AIG was nationalised and the other investment banks were given huge bail outs. (At present something like $10 trillion have been pumped into the US banking system by the Bush and Obama governments).
As the investment banks began to fail, commercial banks refused to lend any further. A bank’s sole measure of stability is the faith of the customers. As Walter Bagehot observed, “Every banker knows that if he has to prove that he is worthy of credit, however good maybe his arguments, in fact his credit is gone.” The banks refused to given loans even to good businesses. This led to a credit crisis. Companies that were starved of credit failed to function. Industrial development came to an abrupt halt. Companies like Chrysler and GM suffered. They too received huge bailouts but yet went to bankruptcy.
The present situation is that the US government’s desperate efforts of bail outs and stimulus packages have revived the US economy. But millions of Americans stand devastated due to the mistakes of a few incompetent banks and subprime lenders. Due to globalisation, the virus has spread through the world. The countries in Europe, including Greece and Italy, have been affected and the European Union is destabilised.
While huge money pumping will work stopgap in staving off recession, it can only be detrimental in the long run. What is needed is strict tightening of the belt and less consumption by Americans. The US is no longer a manufacturing economy. The do not produce goods but only shuffle paper (a.k.a. a service economy). They have a huge trade deficit due to massive borrowings and due to huge imports from other countries, especially China.
One should not be enamoured by the American lifestyle. Behind the glitz and glamour, the American way of living for too long has been bankrolled by borrowings from hard-working Chinese and Japanese. As of 2009, each American owes $24,000 with $2,500 to China alone. It is time for the US to heed the wake-up call and reduce reckless spending.
For further reading on the 2008 crisis, I recommend:
1. Peter D Schiff, Crash Proof 2.0 (2011).
2. Andrew Ross Sorkin, Too Big To Fail (2010).
3. Roger Lowenstein, The End of Wall Street (2010).
4. Michael Lewis, The Big Short (2011).
(The author is a PhD from IIT-Bombay and is currently working as an Associate Professor at VIT University, Vellore Campus. He can be reached at [email protected])