Financial crash: A system in chaos

September 20, 2008

The latest chaos on Wall Street — the worst financial upheaval in the US since the 1930s Great Depression — highlights not just the scale of the world financial crisis, but the needless destruction caused by the blind competition at the core of capitalism.

The Wall Street crisis will almost certainly make the current economic slump worse. A shadow banking system beyond the reach of regulators in the US or any other country is crashing down, destabilising the world financial system.

Even before the latest crisis, Bill Gross of Pimco, a big money-management firm, warned that an uncontrolled liquidation of debt by financial institutions "can turn a campfire into a forest fire, a mild asset bear market into a destructive financial tsunami".

The risk of such a catastrophe is growing. As hundreds of billions of dollars in financial assets vaporise, banks will be forced to raise interest rates to increase the amount of money they have in their reserves. This, in turn, will cut off credit to business and consumers alike, further choking an anaemic economy.

Falling tax revenues will trigger painful cuts in social spending. Home prices will continue their downward slide, and the number of home foreclosures will rise. The unemployment rate will jump still higher.

Workers who do hold onto their jobs will have already seen their real income cut this year due to inflation and shorter working hours — and they'll face renewed employer attempts to slash pay and pass on the costs of health care.

In short, the financial turmoil threatens to turn an already bad recession into something the US hasn't experienced in decades.

The wreckage in the financial markets has also left the US economic model in ruins.

Since the mid-1970s, "corporate America" and the politicians of both capitalist parties have championed supposedly "free market" solutions involving deregulation of business, privatisation of government services and "flexible" labour markets, based on weak unions and an increase in the use of part-time, temporary and contract workers.

But now, after decades of preaching "personal responsibility" to working people and attacking the poor for their "dependence" on welfare, Wall Street is running to the government for multi-billion-dollar bailouts and emergency low-interest loans, all at the taxpayers' expense.

The nationalisation of Fannie Mae and Freddie Mac, the government-sponsored mortgage companies that own or guarantee nearly half the nation's US$12 trillion in mortgages, committed up to $200 billion in government money to make sure that holders of the companies' bonds get their investments back.

The Fannie-Freddie bailout came just six months after the Federal Reserve Bank stepped in to provide $29 billion in taxpayers' money to finance JPMorgan Chase's takeover of the investment bank Bear Stearns.

The Fed also used a Depression-era law to create special "lending facilities" to funnel billions more in low-interest loans to troubled Wall Street investment banks like Lehman Brothers.

Federal Reserve Bank chair Ben Bernanke and treasury secretary Henry Paulson claimed that such moves would prevent a repeat of the debacle at Bear Stearns, which went into crisis because of a decline in the value of the mortgage-backed securities that it owned.

The Fed even agreed to accept some toxic mortgage-backed securities as collateral for those loans.

Now, with the Fannie-Freddie nationalisation and Lehman's bankruptcy, this strategy has failed spectacularly. With $639 billion in assets set to be liquidated, Lehman's bankruptcy is six times bigger than that of WorldCom, which went bust in 2002.

This time around, the Fed and the Treasury refused to finance a rival bank's takeover of Lehman, as they had done with Bear Stearns.

Whether the decision to let Lehman go down was made because another bailout wasn't politically defensible or because the Fed simply didn't have the money available isn't yet clear. But it was an enormous gamble.

"Mr. Paulson seems to be betting that the financial system — bolstered, it must be said, by those special credit lines — can handle the shock of a Lehman failure", wrote economist Paul Krugman in his New York Times column. "We'll find out soon whether he was brave or foolish."

Lehman won't be the only financial titan to bite the dust. An even more famous Wall Street firm, Merrill Lynch, had to sell itself to Bank of America in order to avoid the same fate.

Just days after Lehman's collapse, AIG, the world's largest insurance company, was handed $85 billion in government funds to avoid bankruptcy.

Washington Mutual, the largest savings and loan in the country, and Wachovia, the fourth-largest bank, could also go under soon.

If either one files for bankruptcy, it would wipe out the Federal Deposit Insurance Corporation (FDIC), which protects deposits up to $100,000. The FDIC has just $50 billion to insure more than $1 trillion in total deposits.

Can falling house prices really be responsible for a crash of this scale?

In fact, the housing bust has acted as a detonator for more powerful explosives — the enormous debts of all kinds piled up in the shadow banking system created by deregulation.

At the center of this banking deregulation effort was former Texas Republican Senator Phil Gramm, now Republican presidential candidate John McCain's leading economic adviser and his likely choice for treasury secretary if he wins the November election.

And it was Democratic president Bill Clinton who signed into law the Gramm-Leach-Bliley Financial Services Modernization Act of 1999, which, as Timothy Canova wrote in a recent issue of Dissent, "swept aside parts of the Glass-Steagall Act of 1933 that had provided significant regulatory firewalls between commercial banks, insurance companies, securities firms and investment banks".

Canova continued: "Banks were suddenly free to load up on riskier investments as long as they did so through affiliated entities such as their own hedge funds and special investment vehicles. Those riskier investments included exotic financial innovations, such as the complex derivatives that were increasingly difficult for even experts to understand or value."

Alistair Barr of MarketWatch summarized the consequences: "The shadow banking system grew rapidly during the past decade, accumulating more than $10 trillion in assets by early 2007. That made it roughly the same size as the traditional banking system, according to the Federal Reserve.

"While this system became a huge and vital source of money to fuel the U.S. economy, the sub-prime mortgage crisis and ensuing credit crunch exposed a major flaw. Unlike regulated banks, which can borrow directly from the government and have federally insured customer deposits, the shadow system didn't have reliable access to short-term borrowing during times of stress.

"Unless radical changes are made to bring this shadow network under an updated regulatory umbrella, the current crisis may be just a gust compared to the storm that would follow a collapse of the global financial system, experts warn."

Whether we're at the brink of such a collapse is anybody's guess.

For example, the unregulated market for "credit default swaps" — a form of insurance for bondholders — is worth a mind-boggling $62 trillion on paper, equivalent to four times the annual gross domestic product of the US

The bankruptcy of Lehman will trigger multibillion-dollar payments from insurers to bondholders. But since these "swaps" are privately traded from one institution to another, no one knows who owes what to whom — or whether they can afford to make such payments.

If they can't, more bankruptcies could follow.

Whatever shape this financial calamity takes, there's one certainty: Capital, as always, will try to push the costs of the crisis onto the backs of working people, both in the US and around the world.

But this time, the insanity of the system has been dramatically exposed.

A financial crisis on a scale unseen for generations will lead millions of people to question why they must make sacrifices for the sake of a tiny minority of wealthy parasites.

It's time to make the case for a new, planned economic system — one that's under the democratic control of working people, aimed at meeting human needs rather than bankers' greed.

[Originally published as an editorial by the September 16 US Socialist Worker,]

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