THE BANKING- AND FINANCIAL CRISIS
Causes of the Crisis and Solutions
By Andreas Willnow
[This study published in August 2010 by the Rosa Luxemburg foundation is translated abridged from the German on the Internet, http://www.rosalux.de/fileadmin/rls_uploads/pdfs/rls_papers/Papers_Banken-Finanzkrise.pdf]
The mortgage- and real estate crisis that is also described as the subprime crisis has hindered the development of the world economy for several years. Now this crisis has expanded to a worldwide financial- and economic crisis. Many people are fearful about the crisis of the global financial world because it increasingly threatens their foundations of life.
In this study the causes and developments that produced the current financial crisis will be probed. The effects of this crisis on the financial- and real-economy and possible counter-strategies will be presented.
1. CAUSES OF THE WORLDWIDE BANKING AND FINANCIAL CRISIS
The banking- and financial crisis that reached its culmination with the collapse of the Lehmann Brothers bank (2008) and the near collapse of Hypo Real Estate in Germany can be causally referred back to several malformations in the development of the framing conditions of the world economy.
1) One problematic tendency in the development of the world economy is the increasing tendency to privatization and deregulation. “The market will set things right,” it was said. The state withdrew more and more from economic life.
The policy of deregulation, liberalization and opening markets led to an enormous redistribution of incomes and assets from “bottom” to the “top.” In the last years the profits of DAX corporations (German corporations listed on the German stock exchange) rose 25% annually. While the dividends increased around 30%, manager salaries skyrocketed 16-19% annually. However real wages and pensions either stagnated or rose only slightly in the same time period and the number of poor children climbed.
Consumption was strangled with the increasing concentration of incomes and assets. Encouraged by the high income concentration, vast amounts of money were pumped into speculative businesses on the financial markets instead of real economic investments.
2) A second cause of the financial crisis is that the financial markets were deregulated by politics. Political controls, monitoring and so forth were driven back. This political initiative was expressed in the following quotation of the former German Central Bank president Hans Tietmeyer at the Davos world economic summit in 1996:
“Gentlemen, you are now all subject to the control of the international financial market.”
In the middle of the 1990s, in the golden age of neoliberalism, there was no criticism of Tietmeyer. Rather Tietmeyer was praised for this remark. But those banks and rating agencies on whom politics hardly imposed any restrictions later broke down in the crisis.
Derivative trading (“bets on the future”) and hedge funds were a large part of the problem. Derivative trading which includes currencies, raw materials and food prices is very problematic. Chances for high profits and also high (individual- and aggregate economic) risks are bound up with derivative trading. Money was increasingly produced on the financial markets independent of the real economy. Bubbles arose which burst sooner or later through the increasing uncoupling of financial- from real economic development.
Hedge funds have a very destabilizing effect because they are very speculative. In addition many banks and rating agencies failed in the crisis with their hedge fund-friendly policy.
3) The unbridled pursuit of profits by banks and other businesses is a third cause of the banking- and financial crisis. While the long-term profit expectation (capital interests) in real estate, government bonds and stocks was between 2 and 7 percent, the profit expectation on the financial markets spiraled upwards. The profit-demand on the financial markets often amounted to 15 to 20%. The annual profit target of Deutsche Bank even spiraled up to 25% by chairman of the board Josef Ackermann. The risks of businesses also rose simultaneously with these exaggerated profit-demands.
The transition from a long-term to a short-term orientation went along with the exaggerated profit goals. Businesses should show clear quarterly profits and no longer long-term. The basic approach of shareholder value sets maximum profits (profit pressures and distribution of dividends) in the center of business policy and no longer long-term investments or the interests of employees.
Stern (popular German magazine) described this change in thinking and attitudes as follows: “Terms like shareholder value – primacy of the shareholder – and profit maximization – stood above everything. Mergers like the merger with the US rival Chrysler should bring synergies. The motto is: from one and one come three. That ten thousand jobs were cancelled was even celebrated by the shareholders with ever-new record stock prices.’
Winzenberg described the change in the world of finance that increasingly pursued maximum profits as its goal in this way: “The conventional principle of lending the money of customers for interest was no longer enough to fulfill the profit dreams of the turbo-capitalists. Investment banks like Goldman Sachs, Merrill Lynch, Bear Stearns or Lehmann Brothers were the greediest businesses. The `deals’ were made there. They head for profits of 20, 30 or more percent a year. The money necessary for such businesses is simply borrowed from other banks at favorable rates.”
4) The special case that credits were often given to indebted families in the US that could not repay them later. In awarding the credits of a bank to families who had either no income or only a trifling income, the risk was very high that these credits could not be paid back.
DEVELOPMENT OF THE MARKET FOR SUBPRIME CREDITS
In 2001 the share of subprime mortgages in the total US mortgage market was very small. It amounted to around five percent or approximately 0 billion. In the next five years, a huge amount of money was spent on these credits. The share of these subprime credits rose to around 20% of the total US mortgage market. Altogether subprime mortgages amounting to 0 billion were awarded in 2006 (cf. Wahl, Peter, 2008: The Subprime Drama, 2008, p.3).
All the credits were condensed by the rating agencies and banks. The individual credits had different risks. The task of the rating agencies was to pack the individual credits in a single package. The rating agencies gave different ratings to the securities (from AAA, AAB and ABB to BBB) which often turned out too good. [The products or financial derivatives sold there are called CDOs, Collateralized Debt Obligations. Collateralized Debt Obligation is a collective term for financial instruments included in the group of Asset Backed Securities and structured credit products. CDOs consist of a portfolio of interest-laden securities. The failure risk rises with the falling rating… CDOs are an important refinancing tool for banks on the capital market.]
Homebuilders faced payment problems and increasingly could not pay back their credits. They sold their credits because they could not repay their credits. The first ones who sold their houses received relatively high prices. Many persons also sold their houses because of falling rents. Suddenly there was a surplus or oversupply in real estate. Prices on the market fell with declining demand. Many of the homebuilders received much less money than they invested in the beginning. Many persons who sold their houses became heavily indebted. The crisis of the homebuilders followed the crisis of the banks that did not receive back their awarded funds. The US mortgage crisis had a worldwide radiation. The banking crisis expanded to an international banking- and credit crisis.
In July 2007 the German Focus journal characterized the financial crisis with the following drastic words: “Rotten credits make waves worldwide, first the US real estate financiers, then hedge funds and now two German banks. The crisis on the US housing market casts great waves worldwide.”
Today the economic and financial world has great pains in ensuring risks and losses.
5) Speculation without a real economic basis was a special characteristic of this crash. Money was created on the financial markets increasingly independent of the real economy. The “real estate bubble” had to burst at some time.
2. FROM THE BRETTON WOODS SYSTEM TO DEREGULATION ON THE INTERNATIONAL FINANCIAL MARKETS
In the past, developments of the real economy and the financial markets did not differ so enormously and wild speculation on the future did not occur. International capital transactions were regulated differently in the past. In the following I will present a brief historical retrospect on how deregulation of the financial market occurred.
After 1944 there were fixed exchange rates and controls on capital transactions. At the end of the 1960s, capital transactions were liberalized. After 1973 the Bretton Woods system and commitment to fixed exchange rates were abolished. Exchange rates and capital transactions were deregulated. The foundations were laid for a development summed up in the following aphorism: “The markets will set everything right.” Market balance appears by itself. Everything is regulated by itself. Further rules or restrictions would only be obstructive for development of the financial markets.” In the 1970s and 1980s this liberalization was carried ou9t in industrial countries. Since the end of the 1980s and in the 1990s, this trend was enforced worldwide by the International Monetary Fund (IMF) and others.
The IMF has applied great pressure on developing- and threshold countries. Developing countries shou9ld only be released from their debts when they yield to the interests of industrial countries, for example by abolishing capital transaction controls, reforming their social systems and subjecting everything to free competition. At the same time the markets of these poor countries were to be opened for corporations from the rich countries.
Beside the deregulation of international capital transactions, the increasing uncoupling of worldwide financial assets from the world social product is another malformation on the financial markets. The world social product is what is actually produced. However financial assets have risen much more than the world social product although both systems always ran relatively the same. The increasing divergence between the two realities is connected to the fact that many of these speculative businesses are handled without any linkage to the aggregate economic development. If the gulf between the two realities grows, value is ultimately created that was not gained in the political economy. Money is created on the stock exchange as in a “gambling casino.” Assets are redistributed from “bottom” to “top.”
In the middle of the 1980s, there was still a strong connection between the goods economy and the financial-economic sphere. Issuing a share on the stock exchange served the business mainly as an instrument to gain “fresh” capital in the form of capital stock. Since the beginning of the 1990s, the financial-economic sphere has increasingly uncoupled from the goods-economy. The stock exchange no longer has the function of a capital collection point for long-term investments. Rather market actors mainly seek to realize high profits by fast buying and selling of shares (speculation).
The worldwide trading volume on the international financi8al markets also strongly increased in the last years. In 1980 the total financial volume held by institutional investors on the financial markets amounted to trillion. In the time period of seven years, this financial volume soared to trillion. In 2000 the whole market amounted to .16 trillion. Since then, this share has constantly risen…
In the last years the fast stock and derivative trade has increased intensely. Many political-economic problems are bound with the increased uncoupling of financial- from real economic development.
In summary, a new variant of capitalist development has become established, the so-called finance-market driven capitalism (“financial-market capitalism”). The financial markets drive the real economy or are the forces dominating it. The profits in the financial sector are higher than those in the real economy. Structural under-investment in the real economy often flows into the financial sector. Negative job effects and rising unemployment are consequences of this development. This also has negative effects on the social welfare systems. Many social expenditures are under close scrutiny and the privatization pressure is intensified on account of the enormous difference between revenues and expenditures in the German social security system. A gigantic redistribution occurs from bottom to top and subsequently a loss in trust in parliamentary democracy.
3. THE EFFECTS OF THE FINANCIAL CRISIS AND THE EFFECTS OF OTHER CRISES
According to the IMF, there were more than 160 financial crises since the end of the Bretton Woods system. In the last years and decades, crises occurred again and again even if the extent of the current real estate- and mortgage crisis is striking. For example, since the 1970s there were the dot.com bubble, the tel.com bubble, the Asian crisis, the Russian crisis and the real estate crisis. Crises erupted again and again. This suggests the financial markets are basically built on them and the crises are system-imminent and not accidental.
Threshold- and developing countries are often the most intensely affected by the financial crises. In the following, the effects of the financial crises on threshold and developing countries will be illustrated with the help of the 1997/98 Asian crisis. In the Asian crisis, massive capital was withdrawn within a short time because of the high share of short-term capital. Three states were very strongly impacted by the effects of the Asian crisis: Indonesia, South Korea and Thailand.
The consequences of the Asian crisis in these developing countries are clear with the help of select indicators, for example
• The gross domestic product per inhabitant fell in all countries, particularly in Indonesia, South Korea and Thailand between 1995 and 1998
• Unemployment rose in these three countries between 1995 and 1998
• The number of poor inhabitants shot up enormously in the period under investigation.
The Asian crisis was joined with an enormous redistribution from bottom to top in all the examined countries.
The numbers from Indonesia, Thailand and South Korea regarding the three indicators (gross domestic product per inhabitant, unemployment, number of poor inhabitants) greatly worsened as a result of the Asian crisis.
The crises always run according to the same cycle. The first phase is marked by rising profit-expectations of worldwide investors in a region triggered by a concrete event… Actors expected rising prices of securities.
In the second phase, capital is enticed and prices rise. Prices climb on account of the rising demand. The rising expectations lead to more and more capital driving up prices again. In the third phase, real economic data lags behind the boom in prices of securities. Some investment products turn out unprofitable. Little is invested in the real economy and more in the financial markets because higher profits can be gained there. Bubbles are recognized, prices fall and capital withdrawal and profit-taking occur.
In the fourth phase, prices fall and securities are sold in a panic. Capital leaves the country and is brought into security abroad. Prices drop very steeply. A devastated economy remains after the withdrawal of international capital. (cf. Attac Austria 2008: Financial Markets, Malformations and Crises, in: http://www.attac.at/6029.html.)
In the worst case, the productive economy can be led into a recession by a financial crisis. As a result, states must often take over guarantees or make direct payments to the banks so private debts pass over to the public authority. Social spending often falls victim to the austerity measures that the state must undertake. Unemployment and poverty increase and the crisis intensifies. The population and above all the poorest population sectors must bear the consequences of the crisis while those financial investors who became indebted with the crisis often emerge with high profits from the crisis and evade all responsibility.
4. REDISTRIBUTION FROM BOTTOM TO TOP – WINNERS AND LOSERS OF DEVELOPMENTS ON THE FINANCIAL MARKETS
On one side, there is still the power of investors and big financial investors. In the past, long-term investments and continuous dividends played an important role on the stock exchange. However a short-term price development and a high distribution are at the center today. The standard today is shareholder value, the higher short-term stock price. Annual salaries for managers that are coupled to stock prices through stock options go into the millions and are hardly understandable in relation to the salaries of employees.
Bill Gates, Warren Buffet and George Soros are among the winners of this development even though the latter as a big speculator has criticized this course. Beside these well-known persons, there are also many winners of this development on the financial markets whose names are not known to the general public. These include John Paulson, founder of the Paulson & Co hedge fund group in New York who speculated on mortgage loans and credit derivatives in the US and realized a profit of over 550 percent and Andrew Lahde from the Lahde Capital hedge fund, Santa Monica, who also speculated in 2006 on falling prices of property, mortgage loans and credit derivatives and realized a profit of over 1000 percent.
On the other side, employees belong to the losers of this development. These persons are afflicted by the crisis in the form of dismissals, wage cuts and location shifts. The salary development of employees and managers differed enormously. While a board member of a DAX business earned 14-times more than an employee in production 20 years ago, his salary today is around 44-times.
Workers are also among the losers of reforms passed in connection with the “restoration of the competitiveness of location Germany.” In this context, Agenda 2010 must be named, the restructuring of the social system, the flexibility of the labor market and the enormous rise of subcontracted work and under-payment. Further reforms labeled “reforms to improve the entrepreneurial spirit” and reductions of assets- and business taxes are part of this series.
That little money is available for public expenditures is another consequence of this development. Spending for health and infrastructure is one example. Gross national income has risen very clearly. But one error of politics is that tax revenue has increased much less in relation to gross national income. The top tax rate fell even under the Red-Green German government. Moreover capital is withdrawn through the tax shelters. This policy of the Red-Green German government is still pursued today de facto when the Maastricht-criteria should be fulfilled and state debts limited.
Public goods are increasingly sold since less money is available for state expenditures. The privatization of the energy- and water supply and the sale of sewage canals, streetcars or exhibition halls to investors are examples. Cross-border leasing businesses were active where on one side capital is gained though later devalued so capital ultimately flees into real estate. 9Since 2004 Cross-border leasing businesses have been prohibited in the US.) Areas like communication, transportation and local public transportation were brought on the stock exchange or privatized. Privatization and deregulation of public services has led to “synergy effects,” increased efficiency in Germany and the loss of at least 600,000 jobs.
5. POSSIBLE ACTION STRATEGIES AS TO THE SUBPRIME CRISIS
Politics tries to react properly to the financial crisis. Even when the financial crisis is not the causal agent and problem solutions are attempted, the system of deregulated financial markets or speculation is very dubious. On one side, massive money is invested in the banking system – altogether the financial volume of the bailout package is 480 billion euro. On the other side, no effective regulation of the financial markets has occurred. The profits of individual persons and institutions gained through speculation in derivative trading and leading to the crisis of the system are preserved.
Politics does have alternatives regarding development on the financial markets. Politics can act against financial markets or stabilize them which is even in their interest. Politics can intervene in a regulatory way. Many organizations have the goal of acting against the financial markets.
The following are minimum demands that could be made on politics in connection with the banking crisis:
• Enforcement of the causal agent principle: the costs must be paid by those who caused the crisis, e.g. stricter manager liability,
• Prohibition of derivative trading (or stricter regulations on derivative trading),
• Prohibition of hedge funds (or at least more rigorous controls and stricter transparency rules),
• Nationalization of rating agencies,
• Strengthening bank oversight; the banks should at least be under legal public controls,
• Introduction of a financial transactions tax to limit short-term speculation,
• Strengthening the position of auditors (and stricter criteria for their licensing).
Those who caused the crisis should pay the costs, for example through introduction of a wealth-tax. Sparing the causal agents of the crisis from financial burdens cannot be justified. Managers should be subject to a more rigorous liability. The state should only agree to partial nationalizations when it has voting rights on the supervisory boards, influence on business policy and access to a portion of the realized profits.
The banks should lose power and concentrate on their core-functions, regulating the credit supply of society and promoting productive investment by awarding credits to businesses. Their business activity must at least be put under public control. Legal public bank oversight must be strengthened. The financial markets must be controlled. Their power must be limited. Risky financial products must be subject to registration. (cf. Attac Austria 2008: Financial Markets, Malformations and Crises, in: http://www.attac.at/6029.html.] Introduction of capital transaction controls, introduction of a financial transactions tax to tax stock exchange transactions, over-the-counter trade and currency trading, strengthening international oversight and draining tax havens are additional proper measures. Vital public necessities should be generally withdrawn from the sphere of influence of the financial markets.
Attac Germany proposes the following package of measures to stabilize the financial markets:
“Four Attac Demands for Stable Markets”
• Drain tax havens!
Tax havens are central for the functioning of the global financial market casino. The super-rich, banks and institutional investors are neither fairly taxed nor regulated and monitored. Tax havens that are mostly answerable to western states and depend on access to the global financial markets could be “drained” without problem.
• Global and EU-wide financial market regulation
Globalized financial markets need global and EU-wide monitoring and control. Otherwise the next crash is only a question of time. Banks and especially highly speculative and aggressive funds must be strictly regulated and certain investment strategies prevented. Risky financial products (derivatives) must be subject to a licensing duty like medicines. Unmonitored “over-the-counter” trade with these products should be prohibited. All transactions must appear on the balance sheets!
• Bank bailouts: the speculators must pay!
States must acquire corresponding shares in bailout actions for degenerate banks. No tax funds may be given for the astronomical manager fees. These must be limited to thirty times the minimum income. The bailout costs should be paid back by the causal agents and profiteers of the crisis through higher taxes on profits and assets in the medium term.
• Transaction taxes against short-term speculation!
Taxation on all kinds of financial transactions would curb speculation and increase the stability of the financial markets. To encourage long-term investments, shareholder voting rights should be coupled to the holding time and stock options (coupling of manager salaries to stock prices) prohibited.
To avoid more financial crises, these demands must be carried out immediately. The Austrian government on the European plane must do its utmost for an effective democratic control of the financial markets!” (Attac Austria 2008. The crisis on the financial markets affects everyone. Action is necessary now. Politics must finally close the global financial casino!
“The Quiet Coup” by Simon Johnson:
“Attac’s Bank Tribunal: The Jury’s Verdict” by Friedhelm Hengsbach:
“Life after the Peak: Everything will Change” by Elmar Altvater
Video: Immanuel Wallerstein and Grace Lee Boggs in Conversation at the 2010 US Social Forum in Detroit
68 minutes www.commondreams.org
Video: Michael Hudson and Richard Wolff - Europe Under the Crunch
www.grittv.org July 31, 2010
We've heard plenty about the recession in the U.S., but what about the rest of the world? Countries across Europe have faced budget crunches and conservative governments are using the crisis as an excuse to roll back the social safety net that most have enjoyed for decades.
Many of the problems--and the solutions--sound sadly familiar. Lowered taxes on the rich and corporations, falling wages, and deregulation led to the crisis, which is being shifted onto the backs of the working class--as Michael Hudson notes, putting the class war back in business. Hudson joins us in studio, along with Richard Wolff, to discuss the economic crisis in Europe, what we can learn about the response to it and apply back at home. Here's a hint: it involves organized labor.
To watch the interview broadcast on GritTv July 31, 2010, click on