federalidea.com

by Rajan Philips

What Marx called “fictitious capital” would seem to have been a more frequent and spectacular destabilizer of real economies than what he elaborately diagnosed as the principal contradiction of capitalism between rising production and stagnating markets. Fictitious capital is that portion of capital that exists on paper and speculation in excess of real assets and real production. The current capital market turmoil in the US is yet another instance of the destabilizing role of fictitious capital-this time manifesting as mortgage securities tied to overvalued property assets. This is the fifth such capital market crisis in the last twenty years, each time tied to a different asset bubble, but by far the worst and with the farthest global reach.

The paradox of capitalism is that it has to grow all the time to survive and it has to create credit to consume its own growth. Credit creation and the sharing of risk are now an industry of their own. More than any other society, historical or contemporary, the United States of America epitomizes both massive consumption and sophisticated credit creation. The American economy relies to the greatest extent on consumer spending amounting to $9 trillion annually, which is 70% of GDP. So much, you might ask, for 300 million Americans, compared to $1 trillion that one billion Chinese consumers spend in an year, and an even smaller $600 billion spent by an equal number of Indians.

The second unique feature of American capitalism according to Alan Greenspan is its method and culture of economic risk management. He should know for as the Chairman of the Federal Reserve Board (the Fed-the American Central Bank) for twenty years (1987-2006) and four Presidents (Reagan, Bush Sr, Clinton and Bush Jr), Greenspan preached and facilitated unregulated risk management and credit creation, leaving it to the market to straighten out the rogue guys. He did not quite say “greed is good”, like Gordon Gekko (Michael Douglas) in the 1987 movie Wall Street, but supported and cultivated a system that amply rewarded and hardly inhibited the CEOs of Wall Street who live and thrive by Gekko’s motto. It is no coincidence that all of the last five capital market crises occurred on or around Greenspan’s watch, and each time the rogue guys have, instead of being straightened out by the market, been bailed out by the government using public money. In other countries, such as Britain, when banks are bailed out they are also nationalized. Not so in America, the government bails out banks in bad times and the banks keep their profits to themselves in good times.

Capital conquests from olive harvest to dot.com bubble

Asset bubbles and derivatives that are now part of the business vocabulary had been anticipated from materially primitive times but with far less devastating consequences. According to a story attributed to Aristotle, a rather poor 6th century B.C. Greek philosopher named Thalus bought an ‘option’ with a small deposit on the next year’s olive harvest which he predicted would be very good. He made money but he did not create a crisis.

An early instance of asset-inflation bubble occurred in 17th century Amsterdam that was the cradle of mercantile capitalism. In what has come to be known as “tulip mania”, tulip buds became popular and people paid high prices not just for the actual buds in hand but those that were still in the ground and even those that were yet to be planted. The bubble burst in February 1637, when merchants who could not get the price they wanted started selling their inventories in a hurry, triggering panic all around. Many people lost loads of money.

After tulip mania, came the railway bubble in 19th century London, where Overend, Gurney & Co, a London discount bank took to investing in railways and leveraged its liabilities four fold over its assets. In May 1866, faced with a run on its branches by customers wanting to withdraw their deposits at the same time, and with its request for help turned down by the Bank of England, the Overend & Gurney bank went into liquidation. The experience made the Bank of England to change its policy and become the lender of last resort to assure banking stability. Twenty four years later, the Bank of England rescued the Baring Bothers Bank, another private bank that was being devastated by its losses in investments in Argentina. Without public rescue the private banking industry would have totally collapsed.

By that time the seductive capital had spread far and wide beyond Europe and set sight on the 20th century inventions of radios and cars in the new world of America. In the late 1920s, speculators went mad creating the new stock market bubbles of radio broadcasting and car manufacturing. On Black Thursday, 24 October 1929, the market crashed as share prices fell by 13%. They fell again by a further 11% on Tuesday following. What began as a recession became the Great Depression. The market eventually bottomed out wiping off 90% of the values of share before the crash, and it would take twenty five years for the Dow Jones industrial average to climb back to its 1929 level. The US economy shrank by half and a third of its workforce lost their jobs. The financial system imploded as nervous customers began the dreadful run on the banks-demanding their deposits all at once. It took three years and a new American President in Franklin Roosevelt before America started the long road to recovery.

Roosevelt gave America the “New Deal”, creating a welfare state based on agricultural reform, trade union rights, social security, and a system of safety nets and relief measures. A key part of the New Deal was establishing the institutional and regulatory framework for overseeing the financial institutions through the Glass-Steagall Act of 1933. The commercial banks dealing with money deposits would be regulated by the government which would also be the lender of last resort. Investment banks, on the other hand, would be less regulated and would be ineligible for government bailout.

These restrictions saw America through twenty five years of postwar prosperity achieved through the grand alliance of the state, business and labour. The rough weather of the 1970s marked by double digit wage-price inflation, oil price hikes, economic stagnation and huge government debts shifted the economic paradigm to monetarism, free market ideology and deregulation. The creeping deregulation of the financial sector led to the emergence of a shadow banking system that effectively bypassed the controls put in place by the Glass-Steagall Act. The Act itself was repealed and replaced by a new law in 1999 under the signature of President Clinton, the popular and the only two-term Democratic President since Roosevelt. As President, Clinton had grown too close to financial lobbyists in office and showed little compunction in repealing Glass-Steagall. Nor could he have resisted the persistent pitch of Alan Greenspan that America’s regulations of the financial institutions were a stifling albatross in the new world of internet capitalism. Americans are reaping the whirlwind now.

Greenspan took office in 1987 as the US was coming out of the 1985 scandal involving the American Savings and Loans banks that thanks to deregulation went beyond their customary mortgage loan business into making unwise investments. Many of them went bankrupt and were bailed out by the government at a price of $150 billion. In October of 1987 the American stock market had the biggest crash since Depression, and the Dow Jones Industrial Average index dropped by 22% on a single day. The crash was exacerbated by the computerized trading system that had come into vogue. Some banks, unable to shut down the computers to end the market hemorrhage, had to use axes to cut the cables off and stop the mainframe computers. The crash also brought home for the first time the global linkages of stock markets.

The global linkages were even more evident in the Long-Term Capital Management (LTCM) hedge fund collapse in 1998, which came as a sequel to the Asian Financial crisis that spread to Brazil and Russia. LTCM’s mathematically inspired system for trading in government bonds for profit went awry when Russia defaulted on its bonds. Again, the Fed led the rescue operation amounting to $3.65 billion. The last crash on Greenspan’s watch was the dot.com crash at the turn of the millennium. As with the car stocks in 1929, the stock market went head over heels for internet companies creating the biggest bubble since the Depression. The bubble burst as the ‘teflon’ Clinton was on his way out and blunderbuss Bush entered the White House. Greenspan managed to keep stimulating growth by aggressively cutting interest rates.

Ides of March comes to Wall Street

The current financial crisis began in the sub-prime mortgage loans business that less than honest lenders forced on less than diligent borrowers. The mortgages were packaged by investment banks and sold as secure investments through the global chain of financial institutions and investors. When mortgagees fell back on their monthly payments as repayment amounts went up, the banks called for foreclosures and the upshot has been a wildfire of diminishing property values, home evacuations, bankruptcies and the collapsing of several financial institutions.

The ides of March came to Wall Street and has left it in a terrible state. The major US and international investment banks involved in sub-prime mortgage securities are set to lose an estimated $300 billion, while the total loss involving homeowners, mortgagees and investors in mortgage securities is estimated to be $1.1 trillion (about 8% of America’s GDP). Even this general meltdown was upstaged by the spectacular collapse of Bear Stearns & Co, an 85-year old and fifth largest US investment bank that had survived the Great Depression and World War II. The company with 15,000 share holding employees was an aggressive and allegedly unscrupulous player in the mortgage securities market. Its market value and share price rose to $18 billion and $170 in January, and crashed to to $3.5 billion and $30 on 14 March, to its enforced sale for $240 million at $2 a share on 16 March. The Federal Reserve Board mediated the fire sale to one of Bear’s competitors, JPMorgan Chase, with $30 billion in public funds underwriting the broken firm’s financial assets.

The rescue operation was part of a concerted and extraordinary decision by the Fed and the Central Banks of Canada, European Union, Switzerland and Japan, to use public funds and bailout investment banks to prevent a repeat of the dreadful Depression era bank runs. In addition, the Fed and the Bush Administration have been persuading the bleeding banks to raise their equity by divesting part of their ownership to cash-rich foreign governments such as Abu Dhabi, Dubai, Kuwait, Qatar, China and South Korea. The Fed-directed sale of Bear Stearns is an example of the proverbial ‘moral hazard’-i.e. rewarding Bear Stearns offers an incentive to others to resort to risky practices to increase profit and expect a government bailout if things go wrong. Politically, the Bush Administration has come under fire for rescuing Wall Street banks while rejecting the pleas to help American homeowners with underwater mortgages. At issue for Bush’s Democratic opponents is his double standard in ignoring the moral hazard principle on profit-rich Wall Street but enforcing it on America’s poorer Main Streets.

No commentator or expert will use the term ‘fictitious capital’ in discussing the current turmoil, but everyone speaks of the effects on the ‘real economy’. The fiction is left implied. The effects on America’s real economy are serious. Americans are buying less and paying more for what they are buying. For an economy that relies on consumer spending amounting to $9 trillion per year, its projected slackening even by a one percent margin is of significant concern. In different parts of the country, property values are falling, mortgage payments are high, and for about 8.8 million households the mortgage debt exceeds the property value. Jobs are being lost in their thousands-107,000 in the private sector, in February, and a further 80,000 in March. Retailers are suffering from sales slowdown, while small industries particularly in the housing sector burdened by debt and squeezed for credit are closing down. Aggressive measures by the US Federal Reserve Board (Fed, the American central bank) to keep the interest rate low are not producing, at least for now, the desired result of improving credit and cash flow to lubricate the economy.

On the other hand, Fed induced low interest rates and the more structural US trade imbalance (imports exceeding exports) are driving the US dollar down relative to other major currencies. In the past year, the dollar has dropped 14% against six major world currencies. Investors are abandoning the US dollar for other currencies, the good old Gold, and commodities. During the last month the price of oil shot up to the record high of $111 per barrel, while that of gold surpassed the $1000 mark per troy ounce for the first time. The low dollar is benefiting American exports but hurting other countries which export to America or deal in dollar exchange for their exports. Countries from China to Sri Lanka are buying up the American dollar to keep their exports competitive.

A global food crisis

While the impact of rising oil price has been around for as long as we remember, the most serious fallout from the current American turmoil could be a global food crisis as investors migrate from the US dollar to grain markets. This migration is already underway and is one of the factors in the rising prices of grain products. Over the last year, the prices of wheat, rice and corn have more than doubled, and food inflation could be the newest bubble for fictitious capital now exorcised from the American property market to target as its next conquest. Turmoil in the rice market will hit billions of hungry stomachs in many countries including Sri Lanka where rice is staple food.

[Paddy field in Sammanthurai-Ampara District, Sri Lanka-file Picture by Dushiyanthini Kanagasabapathipillai]

Food riots and protests against rising prices have been reported in the Emirates, Egypt and North and sub-Saharan African countries. Egypt has banned the export of rice to keep sufficient quantities of rice available if wheat supplies cannot cope with demand. In Thailand, the world’s largest rice producer and exporter, farmers are reportedly sleeping in their fields to protect their produce from thieves. The government of Vietnam, the second largest exporter of rice, is raising the export price of rice to contain domestic food inflation. India, the second largest rice producer, has raised the export price of non-basmati rice from $650 to $1000 to prevent domestic rice shortages. Ironically, the biggest victims of this export restriction would be Indian and other South Asian workers in the Middle East. The migrant workers in the UAE recently showed rare militancy in staging street protests against low wages in the face of rising cost of living.

There are a number of other important and perhaps more permanent factors than financial speculation behind the growing supply-demand imbalance in food. The world consumes about 440 million metric tons of rice an year, and the current rice inventory worldwide is estimated to be 72 million metric tons, or 17% of the annual need, the lowest level since the 1970s. Similarly, wheat inventories are expected to hit their lowest level since 1946. Population growth is the biggest permanent factor behind the rising demand, and the growing prosperity in China and India is changing not only how much these large populations eat but also what they eat. For instance, meat consumption in China is increasing as people from villages migrate to cities, and as always the demand for meat diverts land and other resources used in producing rice and wheat to producing grain for the livestock. China is now living out the old argument against hamburgers–eight pounds of grain go into producing one pound of meat.

The demand for ethanol as a vehicular fuel in the US, Europe and Brazil is similarly diverting resources from wheat and rice to producing corn and soybeans, besides removing the latter from food stocks. Climate and global warming are also contributing to the drop in rice and wheat production. Australia, the second largest grain exporter, faced the worst drought in a century in 2006 and its annual grain harvest dropped from 25 million metric tons to under 10 million metric tons. The UN World Food Programme has warned that unless it receives $500 million from donor countries it will have to start rationing its food aid program because of the high prices.

The Sri Lankan government seems ready to contribute its own mite to the gathering storm outside. Apart from creating a homemade inflation (now registering 28.1% or 23.8% depending on whether the old or new measure is used), the government is apparently “permitting and promoting a private oligopoly in the rice market” that is contriving to keep rice prices inordinately high despite plentiful domestic production. The Sri Lankan rice sharks are reportedly buying rice to sell as animal fodder, while their lesser brethren are struggling to pay the price for rice as human food.