The Irresponsible Caretaker & the Financial Crisis
Is this is just another recession?
The economies of the richest and most powerful countries of the West that created the current global financial and trading system have taken a massive direct hit, and the world is in shock. The indirect repercussions of this are affecting the developing countries whose economies are linked to these rich countries and their financial and trading networks. Most of the biggest and most powerful corporations of the world were humbled in 2008 and many would have collapsed without government supports: Citigroup (the world’s largest banking/investment corporation), AIG (the world’s biggest insurer), Goldman Sachs, Blackstone, MasterCard, Bank of America, Wachovia Bank, Barclays Bank, Indy Mac Bank, Royal Bank of Scotland, Lehman Brothers, Washington Mutual, Fannie Mae and Freddie Mac (the world’s largest housing credit corporations), UBS (Swiss bank), Northern Rock, Bradford & Bingley, Merrill Lynch, Bear Stearns, General Motors, etc. The list of troubled gilt-edged corporations runs into thousands and the list is expanding.
The US that bestrode the world like a colossus is hurting badly. Prime Minister Vladimir Putin of Russia, who has been under constant attack from the West because of his independence (unlike his predecessor Boris Yeltsin) was now able to say his piece at the 2009 Davos Economic Forum.
“I just want to remind you that, just a year ago, the American delegates speaking from this rostrum emphasised the US economy’s fundamental stability and its cloudless prospects. Today, investment banks, the pride of Wall Street, have virtually ceased to exist. In just 12 months, they have posted losses exceeding the profits they made in the last 25 years. This example alone reflects the real situation better than any criticism.”
As expected, the Davos meeting this year had no coverage in the US media unlike in the past.
The USA and the EU have allocated trillions of dollars worth of government funds to prop up ailing private sector transnational corporate giants and help debt-ridden consumers. The US alone is allocating $1.65 trillion for corporate bailouts and additional public spending to save the economy. To give Sri Lankan readers a perspective of these colossal sums, it must be remembered that the entire annual Gross Domestic Product (GDP) of Sri Lanka is $42 billion. The so-called stimulus package in the USA exceeds the GDP of the huge nation of India ($1.24 trillion).
President Ronald Reagan, the most revered President in recent USA history, solemnly intoned in his most dramatic rhetoric to the US public that “The Government is not the cure, the Government is the problem.” This has become almost a biblical prophesy with many Americans. The fact that they can still reconcile this with the most extravagant donations of public money to failing private corporate profiteers is a measure of the country’s genius for equivocation.
The nature, extent and the causes of this crisis have been obfuscated by the mainstream corporate-owned media in the West using TV talk show hosts, TV panel discussions, media articles by experts, etc. While problems in developing countries can be magnified, a crisis at home needs to be downplayed with reassurances to their own public and the rest of the world. After all, these same countries have been advising, and often demanding, that developing countries should follow their guidance in organizing their economies and political systems. While the USA and the EU are in the eye of the storm, it is astonishing to see television shows and the mainstream media discussing the possible collapse of the Chinese and Indian economies without confronting the egregious problems in their own domestic economies. The UK-based Economist had a recent issue featuring a possible economic downfall and consequent social unrest in both China and India without a hint of the dire situation in the UK which, according to a recent IMF review, will be the worst affected country.
Visible causes of financial crisis
The roots of the current problem lie in the US economy and financial system that dominates and dictates most of the world economy. Because of this dominant role, the rest of the world is affected, either for the better or the worse by its performance. And it is because of this same dominance that the rest of the world has to find accommodation to US needs. If by some remote chance (in reality, an impossibility), a developing country was able to cause anything close to this level of distress to the entire world economy, it would probably have been invaded and its assets seized as compensation, and its leaders probably tried by international courts. But this is “Made in USA”, not like all the other products in the market that are Made in China or some other developing country.
When the US housing bubble started collapsing in 2008 the public were initially reassured that this was the usual pattern of capitalist economics with long periods of growth and prosperity followed by a short periods of decline for market corrections, something that had to be endured for a while. President George Bush kept reassuring the world that “the fundamentals of the US economy are sound” till it was obvious that they were not. As the crisis deepened with the collapse of US housing credit corporations, Fanny Mae and Freddie Mac, and several Wall Street giants, the story changed a bit and corporate chiefs were accused of incompetence or greed. Some top officials in the USA administration blamed China, accusing it of under-valuing its currency to flood the market with cheap Chinese products and undermine US industry. But reassurances continued that these hurdles could be overcome by massive government bailouts and subsidies. The deeper causes of the crisis are rarely discussed publicly.
The main assets of a US citizen are his house and his retirement benefits. The US housing market, which was valued at US$13 trillion in 2006, lost 30% by end 2008. The retirement benefits, worth US$10.3 trillion, declined by 25% during the same period. It was then announced that the US economy was in recession since end-2007.
I heard the first academic media analysis of the current financial crisis in November 2008 on Japanese national TV, NHK, featuring a professor from Tokyo University. The catalyst that triggered the crisis was the huge US sub-prime mortgage housing loans that went bad. Sub-prime mortgages are loans given to borrowers who have poor credit ratings against the security of the assets, in this case the houses that were purchased. Many borrowers were even unable to make a down payment on the houses but still got the loans anyway.
Why did financial institutions act in this seemingly irrational manner by giving risky loans? There are several reasons. One was that there was excess liquidity because the US Federal Reserve was flooding the system with easy credit precisely to encourage the housing market bubble which was propelling the expansion of an otherwise slackening US economy. The other was that the government was dismantling even the existing weak regulatory controls on speculative financing to encourage market expansion. Another was that lenders felt they could escape the consequences of sub-prime loans by leveraging the risks through a form of derivatives known as Credit Default Swaps.
The role of derivatives
Up until 2001, loans given out by financial institutions were generally secured against loss by bank guarantees. Bank guarantees are comparatively expensive and have stricter security requirements. After that date, these institutions were allowed to insure the transactions with insurance companies, a much cheaper avenue as insurance premiums are less expensive. Hence the massive involvement of AIG and the two major quasi-government housing loan guarantors, Freddie Mac and Fanny Mae, who were helping to propel the house market in the USA. Loans given out in this market, whether housing or car loans or credit card debt, are not retained by the lender. Within days, the loans are re-packaged and sold as Credit Deposit Swaps (CDS) to other financial institutions who in turn sell it to others, creating a chain of CDS holders around the world.
The total value of US sub-prime housing mortgages which were at around $500 billion in 2005 rose to US$3.0 trillion by 2008. The notional value of the chain of CDSs set off by this amounted to US$64 trillion, a staggering sum that exceeds the GDP of the whole world which stands at US$56 trillion.
CDSs are a form of unregulated derivatives. Inordinate business risks can be taken today because these can be leveraged through the use of derivatives. Derivatives are used for all manner of speculative business decisions involving future scenarios that can range from the price of commodities in the commodity exchanges, stocks, currency exchange rates, interest rates, inflation levels or even the weather conditions.
Basically, there are three categories of derivatives: futures, options and swaps. Credit derivatives derived from loans, bonds and other credit issues are swaps. While most futures and options are traded through formal Trade Exchanges which act as trading houses and are subject to some regulation, swaps are over-the-counter derivatives that are privately negotiated and unregulated. The Bank of International Settlements in Basle, Switzerland, that is the window for arranging settlement of these transactions, estimates that the notional value of the total derivatives market is now over $700 trillion of which about 8% are swaps.
The operation of derivatives is not easily understood by the uninitiated as the Sri Lanka Petroleum Corporation has learnt the hard, brutal way. The world’s richest man and perhaps the biggest philanthropist today, Warren Buffet, wrote to the shareholders of his immensely successful company, Berkshire Hathaway, in 2002 as follows:
“We try to be alert to any sort of mega-catastrophe risk, and that posture may make us unduly appreciative about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial instruments of mass destruction, carrying dangers that, while latent, are potentially lethal.”
Similar thoughts were expressed by the billionaire financial strategist, George Soros, for many years.
The high price of de-regulation
The reader may wonder why there should be risks if the housing loans were secured against real estate. The problem was that the increased demand for housing in the USA caused by easy credit resulted in a giant escalation of house prices and corresponding loans. House prices that usually rose annually by 2-3% increased by 50-100% within a few years. Since houses are the main asset held by many US households, increasing housing values had encouraged people to take additional secondary or even tertiary mortgages on their houses and indulge in more extravagant spending. When millions of sub-prime mortgage borrowers began defaulting in large numbers, lenders began restricting credit and even calling upon borrowers to double their monthly payments to make up for losses created by defaulting borrowers. Housing prices declined sharply and the value of the collateral then fell below the value of the loans. The sheer volume of losses in such a short time, amounting to around $3.0 trillion, set in motion a train of defaulting CDSs around the financial world. These had now become toxic assets.
Again we may ask why financial institutions worldwide bought these CDSs based on high risk sub-prime mortgages, hoping to make a long-term profit. The answer is that risk assessment agencies in the USA like Moody’s and Standard & Poor classified these junk bonds as AAA class securities, giving assurance to institutions around the world looking for good investments. These same US rating agencies downgraded the Sri Lanka government’s previous bond issue. The financial world implicitly trusted these agencies to tell them the truth and were cheated and lost their investments. The Chinese and Japanese economists and bankers have described this as “the financial tsunami unleashed by the USA on the world”.
The housing bubble accompanied a stock market bubble in Wall Street. Speculative trading in stocks was the fashion with day traders and short sellers for several decades. Corporations also worked to show immediate profits at the expense of long-term sustainability as this propelled their stock prices which in turn enabled corporate managers to award themselves million dollar salary increases and bonuses. Some high profile corporations even cooked the books and used “creative accounting” to show non-existent profit gains. When both these bubbles burst the US economy which had flourished on the paper money created by these financial speculations was in deep trouble.
President Barak Obama, the brand new American President, plans to spend around US $850 billion on “stimulus packages” and is confident that “the greatness of the American people” will enable them to overcome this crisis. This is in addition to the US$800 billion already allocated by the earlier Bush administration. It is suggested that more will be required. At the time earlier President Bush passed his stimulus package the USA National Debt was already US$10.7 trillion by end-2008. With the additional stimulus packages and the ever accumulating US debt, the US National Debt will surpass US$13 trillion by end-2009. Can these debts be securitized and sold to foreign countries and the US public? This is an unlikely prospect, considering the recent performance of the US economy. So the US Federal Reserve must simply print the dollars.
The USA and the UK are the most spectacular victims of the crisis they helped to create: over half million US workers have been losing their jobs each month in the recent past; 171 US banks and financial institutions were close to failure and in need of assistance and over two thousand others were in distress by end-2008. Several millions have lost their homes and at least a good part of their savings. Now, Americans, corporations and citizens, are looking to their government to be rescued through huge financial bailouts and social and public spending.
Sri Lankans should take heart that the country has been relatively unscathed, apart from the loss of some foreign employment and export revenues. The Sri Lankan banking and financial systems are secure, despite the decline in foreign exchange earnings, because of the sound regulatory system of the Central Bank of Sri Lanka. Unemployment is at an all time low due to numerous infrastructure projects. It is to the credit of the Sri Lanka Government that in spite of pressure from international agencies and foreign advisors, Sri Lanka declined to fully liberalise its currency and its exchange regulations and privatise the state banks. If they had succumbed to these pressures, the Sri Lankan economy would have also have faced a possible collapse.
Debt-based prosperity
But to understand the real roots of this international crisis, we have to go back into history to the changes in the international situation immediately after World War 2. The “Allied Nations”, comprising 44 countries that were among the victors in the war, gathered in July 1944 in Bretton Woods, New Hampshire, USA, to design the framework of the new world economy. The USA was the only country that did not see war on its soil (except for the bombing of Pearl Harbour) and it was now overwhelmingly the world’s strongest economy and the only large creditor nation.
The meeting agreed to establish the International Bank for Reconstruction and Development (better known now as the World Bank organisations), the General Agreement on Tariffs and Trade (GATT) and the International Monetary Fund (IMF). They also agreed to create an exchange rate mechanism with the US dollar as the international currency against which all other currencies would establish their exchange rate. The British Pound was no longer supreme as the country’s economy was in heavy debt due to war expenditure. The US dollar value was established at 1/35th ounce of gold and this rate of exchange was assured to anyone wanting to cash dollars for gold. The dollar was now the international reserve currency and is still the main currency used in international transactions. But the USA has not been a responsible caretaker of the world’s international currency. That is the main problem of the world today.
The idea did not go unopposed. The British delegate to the conference was the renowned economist, John Maynard Keynes. Instead of a reserve currency he proposed an International Clearing Union that would be a supra international bank and regulate payments for trade transactions and issue its own currency, the bancor. Participating nations would be forced keep their deficits within limits or face punishment through higher interest rates on bancor-based credits. The US delegate Harry Dexter White rejected the proposal and his voice was the most important. He also secured US control over the IBRD and the IMF, giving it veto powers over their decisions.
Currency based on the gold standard could not be sustained by the USA. With its dominant position as the reserve currency, the US Federal Reserve could not be prevented from expanding the dollar supply to meet the expanding global ambitions of the USA by merely creating new money to meet its needs. France, under Charles de Gaulle, called the bluff by exchanging much of its US dollar reserves for their gold equivalent. Then the huge expenses incurred by the US during the Vietnam War required the creation of massive amounts of dollars and in 1971 President Richard Nixon unilaterally abandoned the gold standard which had been created by a multi-lateral agreement.
Since that date the US has felt free to create dollars whenever they needed it as they felt the rest of the world had no choice in the matter. The agreement with OPEC oil producers in the 1970s that oil should only be sold for dollars, exchange for military guarantees to protect the Middle East rulers, ensured the continuation of this as the oil market is the biggest commodity market in the world. It is also the reason why the US strongly resisted the creation of the euro currency though its efforts failed. A part of the dollars created are securitized through the sale of Treasury Bills, bonds and stocks which are bought up both by US citizens and foreign countries holding large dollar reserves. As a result of huge public spending on the military and foreign wars while taxes were being drastically reduced, first under President Ronald Reagan, and much more under President George Bush, the US national debt ballooned to US$10.7 trillion by the time President Bush departed this year.
Both the US government and its citizens have been profligate. While the government indulged in massive spending, primarily for the military (former World bank Chief Economist Joseph Stiglitz estimates the real cost of the Iraq War will be US$3.0 trillion), US citizens lived lavishly on never-ending credit. The US personal savings rate is near zero compared with the Chinese savings rate of 40% of earnings. Americans had got to the point where they implicitly believed that they could survive happily with ever increasing debt because “this is America and nothing can challenge us.”
Many economists have been warning the US government that this level of debt is unsustainable. But others have openly declared that since the dollar is the reserve currency the world would have no option but to accept the increasing US public debt. In the present situation, this may not be assured. US Congressman Ron Paul, a Republican from Texas, in a brilliant speech to the US Congress in February 2006 on the vulnerability of the US economy, made this comment.
“Even with all the shortcomings of the fiat monetary system, the dollar influence thrived. The results seemed beneficial, but gross distortions built into the system remained. And true to form, Washington politicians are only too anxious to solve the problems cropping up with window dressing, while failing to understand and deal with the underlying flawed policy. Protectionism, fixing exchange rates, punitive tariffs, politically motivated sanctions, corporate subsidies, international trade management, price controls, interest and wage controls, super-nationalist sentiments, threats of force, and even war are resorted to – all to solve the problems artificially created by deeply flawed monetary and economic systems.”
Russian Premier Vladimir Putin speaking at the World Economic Forum in Davos called for the end of the role of the US dollar as the main international reserve currency and called for the acceptance of other leading currencies in that role. Former President Bill Clinton, addressing the conference, accepted the statement of the Chinese Premier that the US created the financial crisis but exhorted other countries with large reserves, particularly China, to help the USA by buying US securities, assuring them that this will help sustain their exports to the USA. In short, export your solid manufactured products and services for unsecured paper which you have paid for. That is the Alice in Wonderland world we live in today.
Even before President George W. Bush, President Bill Clinton had contributed to the financial de-regulation of the US banking system by repealing the Glass-Steagall Act in 1999 which had separated the commercial banks (which were based on deposits) and investment banks (which are investors and risk takers).
The sincerity of President Barak Obama to solve the crisis in the USA is unquestioned. But he is mandated to solve the problems in the USA, not the consequences the problem the US has created for the rest of the world. At the same time, as the Hon Ron Paul states, he has to deal with the mindset of most Americans that they are the greatest and their systems are the best for the rest of the world. The US has the greatest pool of talent in the world drawn from every country due to its liberal immigration policies: scientists, academics, researchers, inventors. It has immense natural resources. It has the best educational institutions and research facilities. It could easily lead the world with these assets. Yet it chose to seek greater prosperity based on financial speculation, reminding us of Marlowe’s Dr. Faustus: “What profits Man to gain the World and lose his Soul?”
Lessons for Developing Countries and Sri Lanka
The local intelligentsia drawn from the urbanites in Colombo are always quick to blame the difficulties faced by Sri Lanka in these troubled times on the government and quote foreign critics with approval. They have little understanding or awareness of the global structures that impact on developing countries. They make themselves loudly heard both locally and in the international media through think tanks and NGOs (happily called Civil Society voices) funded by foreign governments or their agencies. While the people of Sri Lanka have democratically elected their government to manage the country, foreign politicians feel they have the right to advise Sri Lanka on how it should manage its economy or conduct its campaigns against terrorism. And the international media will blithely discredit the government’s views and claim that these “civil societies’ reflect the true voice of the people.
What are the lessons of the financial meltdown in the USA and the problems of the EU for developing countries like Sri Lanka? The most important is that the economic and political theories propagated by the Western powers and supported through the international and bilateral aid agencies they control should not be accepted at face value. Countries must prepare their own development plans based on their country situation and their own priorities. The structural adjustment and trade liberalization programs the West sponsored have often been based on self-interest rather than pure charity. Take one example. When the East Asian financial crisis broke out in 1997/98 due to a heavy reliance on speculative international finance flows for massive investments that went bad, the Washington Consensus (comprising the World Bank, IMF, US Treasury) advocated rigid adherence to market principles: Failing corporations and financial institutions must be allowed to fail or be acquired by Western investors; aid money would only be provided to repay foreign creditors; credit must be tightened; interest rates must be increased, etc. But when the recent financial crisis hit the Western powers, the medicine is the very opposite of all these they recommended to others.
The second is that developing countries should not be heavily export-oriented towards the USA and the EU, neglecting the development of their own national markets and inter-regional trade. China, sensing a possible crisis, had started investing in developing their huge national market for some time. India, with its own big population, is also well placed in this regard. Both these countries can help the smaller countries in the Asian region to be integrated within more organised regional trade and economic development networks. Both the ASEAN and SAARC organisations are still far from integration compared to the EU.
Developing countries need to avoid speculative finance and unregulated markets while fostering private sector-led economic growth. Sri Lanka’s first ill-conceived venture into the derivatives market over oil price stability should be a hard lesson on the operation both of derivatives and the international banks that sponsored the project.
Apart from the infrastructure development work already in progress in Sri Lanka, which is highly commendable and will pave the path for future prosperity, the government also needs more investment in rural agricultural development. One of the handicaps faced by rural producers is the insufficiency of marketing services for rural products. This can be only be improved by the provision of more wholesale market facilities in the production areas that will be able to attract commercial buyers from outside the region to break the monopoly of the main traders who tend to control markets and producer prices.
But a very important factor is the need to invest in quality higher education and research. The modern world economy will always be led by countries that have high level technology and the capability for technological innovation. The national investment in research, both in the private and public sectors, is minimal. Sri Lanka universities, with its main focus on a limited range of Liberal Arts, lags behind many other developing countries. The universities are insulated to a large extent from learning and research that has been developed elsewhere. The academic courses and teaching is inbred. Every big university in the USA has leading academics from other countries in their faculty. Even when I was in the Ceylon University in the 1950s we still had a number of outstanding foreign professors. Sadly, the situation is now quite different. The universities in Sri Lanka make a minimal contribution to economic development, despite the heavy investments by the government.
With all the goodwill in the world, no country has prospered with foreign aid alone. Each nation has to plan and create its own future. The great powers of the world are primarily interested in fostering their own interests, as is to be expected. It is useful to recall the statement of Lord Palmerston, Foreign Minister and Prime Minister of Britain in the mid-19th century when Britain was the greatest imperial power in the world: “England has no eternal friends, England has no perpetual enemies, England has only eternal and perpetual interests.”
Kenneth Abeywickrama
February 2009
(This article was first published in the Ceylon Daily News, Sri Lanka’s leading national English daily, in April 2009, in 3 instalments.)