By Eva Cheng
"There is a credit crisis going on around the world, and it was brought home to us in spades by the bailout", Henry Cavanna, the head of JP Morgan Investment Management told Bloomberg news agency on September 25. Cavanna was commenting on the bailout of US hedge fund Long-Term Capital Management (LTCM).
He also warned: "All the major banks and brokerages have exposure. We are not out of the woods yet" (emphasis added).
Cavanna is one of a growing number of capitalist commentators who are being a bit more honest lately about the ferocity and danger of the economic crisis that has engulfed the capitalist system since last year.
While Cavanna was speaking, his US-based firm and 15 other top US and European financial institutions were resisting pressure from the Federal Reserve, the US central bank, to fork out huge sums to keep LTCM afloat.
JP Morgan was asked to contribute US$300 million to the $3.65 billion rescue. Of the 16 financial houses, only three were asked to provide a smaller amount.
All of them have already suffered significant losses from the upheavals in the world financial markets, especially from LTCM's troubles: Credit Suisse expects to lose $55 million; Dresdner Bank $144 million; and Switzerland's UBS wrote off up to $718.9 million, which includes losses from the Third World.
All 16 eventually agreed to join the bailout. If they had not, it is likely they would have been hurt much more. As creditors, the collapse will dash any possibility that their receivables from the LTCM will be repaid. By keeping it afloat, at least there's a chance of repayment.
More importantly, the rescue will help prevent the entire financial market being pushed to the edge, putting at risk other assets and the viability of many other businesses.
A big danger of the LTCM collapse comes from the large number of speculative funds that have been dealt a blow by the wild swings in the financial market since mid-1997. Among these, hedge funds alone number 3000.
High risk
Hedge funds are only one of many homes in which the vast pool of unproductive capital in the world today seeks shelter. But they are among the riskiest: they are highly leveraged and, more importantly, have obtained huge loans from banks.
By engaging in simultaneous two-way bets, hedge funds seek to exploit the temporary price discrepancies of a particular financial vehicle. The potential gaps were bigger decades ago when hedge funds were first introduced, but much smaller as trading technology advanced.
As the profit margin gets thinner, the size of the bet has to increase to maintain profitability. To finance the enormous bets, hedge funds obtain most of their funding from borrowing. The LTCM was reportedly able to hold $125 billion worth of open positions earlier this year on the basis of merely $2.7 billion of shareholders' funds!
With limited demand for funds for productive investment, banks have been lending to hedge funds, which offer lucrative interest payments.
The banks' involvement greatly increases the risk. Due to their critical role in funding production and product sales, banks can shake the capitalist system. When in trouble, they can drag many businesses down simply by turning off the credit tap, triggering a chain of defaults.
Moreover, major imperialist banks have already been weakened by the global crisis, which first exploded in Asia last year and hit Japanese banks hardest.
But with Russia and Latin America also hurt by a slump in their crucial energy and other commodity income, their key creditors — US and European banks — are endangered as well. An added blow from hedge funds can tip the banks over the edge.
Overcapacity
The pool of unproductive capital is growing as capitalists battle the long-standing problem of inadequate sales. Capitalists' pursuit of maximum profit has not only impoverished workers but also depressed sales, because workers are also consumers.
For some capitalists, the sales problem is eased by pushing their products overseas. However, while overseas competitors are trying to do the same, capitalists' overall sales problem keeps growing.
The financial market's initial function, to raise funds for production and facilitate sales, has long been displaced by speculation. If the correct "bets" are made, speculation gives a much higher "yield" than production of goods and services.
The growing need of imperialist governments to soften the blow of the overcapacity crisis — by propping up business and increasing public works — has led to increasing deficit spending, funded by bond issues. The issues got bigger as the scale of each overcapacity crisis grew with the rapidly developing productive forces. This boosted the financial market.
But stocks remain the most desirable item because of their potential profitability. With a global stock market capitalisation of $14 trillion in 1993, supply was dwarfed by the $21 trillion of insurance, pension and mutual funds that were hunting for a home in lucrative stocks. They were also competing with $38 trillion in savings from the six richest countries alone, which were also looking for a high yield shelter.
It is estimated that only 1% of these funds have gone to Third World stock exchanges. But, because of the latter's tiny sizes, the small portion of the institutional funds invested there is enough to turn these stock exchanges upside down if the funds are withdraw — as has been the case since last year in Asia, Russia and Latin America.
To facilitate speculation, speculative vehicles called derivatives were created. These derive their value from other existing vehicles. Like hedge funds, on the pretext of their high entry cost, they are also subjected to minimal regulation.
But the potential damage that derivatives can cause grows with their size. Outstanding derivatives in exchanges already reached $8.64 trillion at the end of March and over-the-counter derivative transactions — those sealed outside exchanges — amounted to a breathtaking $47.5 trillion. Banks are a key player in derivatives.
Yet even the minimal rules were ignored by derivative traders. In mid-September, the Bank of International Settlement, the central bank of central banks, revealed that up to 20% of dealers, apparently in a bid to speed up transactions, ignored the required contract procedure, which left them totally unprotected if the other party defaulted.
Defaults are common in a volatile market, and they can prompt many more defaults.
Deficit spending and bailouts were applied once again to deal with a crisis caused decisively by overcapacity. But these remedies do not address this critical question.
Bailouts and more public spending can at best pull things from the edge, but they will be of little use in boosting production and demand. The scale and ferocity of the next crisis will be bigger.
Solving the crisis
The International Monetary Fund was created in the wake of World War II — itself triggered by an overcapacity crisis — to deal with economic crises more "systematically". But the present crisis clearly reveals its ineffectiveness.
After spending nearly $50 billion in four rescues — Thailand, South Korea, Thailand and Russia — worth nearly $150 billion, the IMF's funding has almost dried up. Its recent offer to help Latin America with close to $30 billion (again partly funded by key imperialist countries) will be of doubtful use.
The US is the IMF's biggest and most decisive member. But US Congress's repeated rejection of the IMF's call for new capital has crippled "the world's lender of last resort".
The world now has the capacity to produce 60 million vehicles a year, but only 44 million were produced. Much less were sold. With temporary exceptions among individual countries or capitalists, it was much the same in other industries. Last year, Japan's idle capacity reportedly reached 2.7%, while France's hit 3.2%, Italy's 3% and Germany's 3.4%.
This excess capacity has to be minimised, and some eliminated, to enable a "recovery". In the past, this has been done through brutal cuts in workers' wages and conditions, massive unemployment, bankruptcies and even war.
Already one-quarter of the world economy is in recession and many capitalist commentators expect the extent of the recession to double next year.
In the present crisis, capitalist governments are using all these means except war. But Japan's Prime Minister Obuchi indicated in September that his only remaining option to revive the Japanese economy was to increase military production.
Despite the rhetoric, Clinton's call for a meeting of 22 key countries in April to address the crisis came to nothing. His recent call for a similar meeting within a month has little chance of remedying the root causes of the crisis.
The present global crisis arose from the very foundation of the capitalist system — its profit before people priority. No solution can emerge without reversing that priority.