Understanding the financial crisis
The ongoing woes of Northern Rock continue to the extent that even the latter-day Thatcherite Lib Dem Treasury spokesperson, Vince Cable, is calling for it to be nationalised. It is clear that something is seriously amiss in the financial system. Capitalism seems unable to shake off the growing sense of crisis.
The root of the problem lies in the failure of profits to recover to the levels seen in the decades after the Second World War. From the early 1970s onwards, the world economy, which had for years grown, began to slow down.
Growth slowed, profits slumped, and unemployment returned to the heart of the system. The tendency of the rate of profit to fall, a long term feature of capitalism that Karl Marx had identified 100 years previously, reasserted itself.
The response of governments throughout the world, tentatively at first but gathering pace over the next 20 years, was to introduce the measures we now know as neoliberalism.
First, great chunks of the state itself were broken up and sold off, releasing huge sums into private capitals' hands – one estimate suggests that around one third of all the value in all the world's stock exchanges comes from privatisation.
Second, controls on the movement of goods, services and – especially – money from country to country were removed, allowing capital to move more freely around the globe.
Third, and most fundamentally, attacks were made on working class standards of living. Capitalism makes profits from paying workers less than the value of what they produce. Often the quickest and easiest way to restore profits is to pay workers less – either directly, in their pay packages, or indirectly, through attacks on the welfare state.
In the US this assault on the working class was successful – between 1975 and 1995 average real wages for full-time male workers in the US stagnated, or even declined slightly. Elsewhere the attacks were less thoroughgoing, but in Europe the welfare systems that had been the social democratic parties' proudest achievements were whittled away, and job insecurity was increased.
These attacks had some success in boosting profits. Growth returned to some areas of the system, but was unevenly distributed – the US economy boomed in the late 1990s and early part of this century, while those in what is now the eurozone in general remained stagnant. Growth was not generalised throughout the developed world.
The picture was even more mixed in the underdeveloped economies. While a few – China being the most spectacular example – were able to hook themselves into the global economy, many, such as those in sub-Saharan Africa, went into steady decline.
There was no return to capitalism’s post-war “golden age”. But the relative underlying weakness of the recovery was masked by the explosive growth of the world financial system.
Financial markets and financial institutions play a very specific role under capitalism. They help coordinate the system, moving capital to wherever it can make the greatest profit.
An individual capitalist may not be able to see where the best profits can be made, anywhere in the world, but the financial markets, collectively, can do this, taking money and redistributing it according to the returns it can make.
Theoretically, financial markets make capitalism work “better” – they will hunt the places where highest profits can be made, and so (theoretically) boost profits throughout the system.
However, the financial system carries two great risks. First, it can misjudge real profits and simply indulge in speculation, with financial markets talking themselves into a frenzy of ever increasing share prices, based on not much more than the whims of traders. These are called “bubbles” and the consequences, when they burst, can be dramatic.
Second, the speed and flexibility with which the financial system can find profits may also turn it against capitalism as a whole, rapidly transmitting a crisis in a single economy into others. This is known as “contagion” – the crisis in one region spreading very rapidly to others.
Since the London stockmarket's so-called “Big Bang” in 1986, when electronic trading was introduced and many of its old rules were torn up, the City was able to build on its historic role to become one of the most important hubs of the new global financial system. The value of traded shares in London has increased by fifteenfold since then, from £161 billion in 1986 to £2.49 trillion today.
Money can be moved round the world at the press of a button. Financial institutions are able to scour the globe looking for profitable opportunities for investment, moving into and out of markets, buying and selling shares, with incredible speed. With some recovery in profit rates on the back of attacks on working class living standards, financial markets were able to suck in more and more money and capital, and so inflate themselves to greater heights.
Moreover, the expansion and growing sophistication of the financial system created an intriguing new possibility for capitalism. It is in every individual capitalists’ interests to pay workers as little as possible to boost profits. But if every capitalist did that, workers would not be able, collectively, to afford what the capitalists, collectively, are selling. What is good for one capitalist is not necessarily good for the system as a whole.
However, by offering cheap loans to workers, capitalists could simultaneously pay workers less and still sell their goods and services. The expansion of the financial system allowed them to do that, tying workers into global finance with cheap loans and easy credit.
The effects are dramatic. In Britain, where this process has perhaps gone furthest, real wages have for the last few years grown weakly, if at all. Yet consumer spending has risen by 40 percent since 1998.
The gap between weak wage growth and rapidly rising consumer expenditure was closed by consumer credit, with individuals in Britain now owing over £1.2 trillion.
But because the underlying rate of profit, though somewhat recovered, remained too low to produce a generalised expansion of capitalism, this new high speed financial system actually rested on very rickety foundations. It could shuffle money around the globe at breakneck speed, but the flow of real profits into the system was much less dramatic.
This increased the risk of speculative “bubbles” developing, and the last 20 years have seen a succession of these, inflating and bursting. But they have not, until now, hit the core of the system.
The bursting of the dotcom bubble in the early part of this decade resulted in some high profile fraud convictions, and some spectacular losses, but swift action by the US government bank, the Federal Reserve Board, prevented it spilling over too far into the real economy.
The Federal Reserve did this by creating another bubble, in the property market, slashing interest rates and encouraging many millions of Americans to keep on borrowing and consuming.
As the property bubble continued to expand, more and more consumers were pulled into its orbit. The subprime lenders sought out, and mis-sold mortgages to, people who otherwise could not afford a mortgage. There were reports of subprime loans being made to those without any income at all.
This is very risky. People who cannot afford interest payments on their loans are at a high risk of defaulting on them, and a small wobble in the property market meant many of these very marginal borrowers suddenly could not afford to keep up with their interest payments. Mortgage lenders were left with billions of dollars of bad debt.
The sophistication of the financial system had encouraged the major banks to engage in increasingly speculative activities. They had been responsible for loaning money to the subprime lenders, who in turn passed the credit on to their own customers. The banks, realising they had difficulties, began to panic. They called in some of their loans, and stopped lending money to each other.
Northern Rock relied on this inter-bank lending to make its money. Banks lend money at a much cheaper rate to each other than they do to you or I – they trust each other not to default, and so charge less.
When banks stopped lending to each other, the company was in serious trouble. And due to the way the financial system ties capitalism together, a serious problem in one small part of the system can rapidly turn into a serious problem, system-wide.
In addition, years of deliberate government policy have tied consumers into the financial system as never before. British consumers owe, on average, 163 percent of the earnings in debt.
The system relies on their borrowing, and others like them across the developed world, to keep running. So a crisis developing in the financial system has the potential not only to hit capitalists’ investments – it can hit workers' consumption.
The last time a financial crisis threatened, the Federal Reserve was able to create a property bubble to keep the system afloat. If the property bubble bursts, it is hard to see what bubble the central banks can create next.
The only real way to deal with this crisis is to boost profits by hammering workers. This helps explain Gordon Brown’s enthusiasm for a public sector pay freeze – he hopes that he can give a lead to British capitalism generally by weakening workers' confidence and keep wages down. He wants them to pay the price for the capitalists' crisis.