â€œThe Deepening Global Financial Crisis:
From Minsky to Marx and Beyondâ€?
By Dr. Jack Rasmus
The origins of todayâ€™s global financial crisis lay not in the collapse of the U.S. subprime mortgage market and subsequent housing debt deflation, but in more fundamental processes and structuresâ€”financial and non-financialâ€”at the root of contemporary capitalist economy.
The subprime mortgage market is but a symptom and reflection of more basic and essential forces at work. To employ a metaphor, the subprime meltdown is to the general financial crisis as a condition of high blood pressure is to diabetes, in a patient in which multiple ailments have begun to manifest. The â€˜realâ€™ ailments afflicting the US economy for more than a quarter century now include sharply rising income inequality, a decades-long real pay freeze for 91 million non-supervisory workers, the accelerating collapse of the U.S. postwar retirement and healthcare systems, export of the U.S. economyâ€™s manufacturing base, near-demise of its labor unions, the lack of full time permanent employment for 40% of the workforce, the diversion of massive amounts of tax revenues to offshore shelters, growing ineffectiveness of traditional monetary and fiscal policy, and the progressive decline of the U.S. dollar in international markets. (1)
These real conditions represent, in final analysis, U.S. Capitalâ€™s successful efforts since the late 1970s to offset declining profitability in spheres of real production and distribution in its prime home market by shifting incomes by various means from tens of millions of wage earners to the wealthiest households and corporations. In parallel, the subprime and the current general financial crisis (and prior financial crises preceding them) reflect a similar underlying drive to shore up profitability by turning increasingly to speculative and super-speculative forms of investment. Thus the â€˜realâ€™ measures of the past three decades share in common with the â€˜financialâ€™ crises the same common denominator: the drive to restore profitability since the late 1970s by evolving and implementing new, non-traditional structures, institutions, and increasingly aggressive policiesâ€”all designed to realize a greater rate of profit from the circulation, as well as the production, of capital.
(1) A more detailed analysis of changes in structures, relations, and policies in the real economy in the US since the late 1970s that were designed to ensure greater profitability at the direct expense of the US working class are described in my 2006 book, THE WAR AT HOME: THE CORPORATE OFFENSIVE FROM RONALD REAGAN TO GEORGE W. BUSH: Economic Class War in America, Kyklos Productions, 2006. The documentation of the quantitative annual shift of more than a $1 trillion in income from US workers to forms of capital incomes (profits, dividends, interest, etc.) is described in still further detail in my forthcoming, THE TRILLION DOLLAR INCOME SHIFT: Essays on Income Inequality in America. These works represent the effort to describe economic class conflict in the US since 1980 and the shift in income to capital from labor that that ongoing conflict has produced.
The revolution in financial structures and relations that has characterized the U.S. economy since the1970sâ€”structures and relations that have produced a series of asset price booms & busts and increasingly frequent and serious financial crises over the past quarter centuryâ€”should be viewed, in other words, as parallel developments to changes in structures, relations, and policies in the â€˜realâ€™ economy since the late 1970s also designed to buttress profitability. Whether real or financial, the drive for profitability amidst systemic counter-pressures reducing profitability is the fundamental endogenous dynamic at work in both sectors, financial and real.
Key questions that logically follow from the above general point include the following: what are the inter-relationships between cycles and crises in the financial and real sectors of the economy since the 1970s? Are financial and real cycles largely independent or interdependent? If to some degree the latter, which historical situations to date most reveal that interdependency? Under what conditions may a cyclical downturn in one sector precipitate and/or exacerbate a crisis and downturn in the other? Do deep depressions, which tend to be global in character, occur when the real and financial cycles (which typically differ in their relative oscillations) converge and approach congruency? Or, to ask the same historically, is the current global financial crisis more similar to 1988-1992, or to 1929-1933?
In Part I to follow this article focuses on the recent financial crisis. Appearing initially in the subprime mortgage sector of the US economy, due to two decades of financial deregulation and the growing relative weight of new financial instruments like derivatives and new institutional forms like structured investment vehicles (SIV), that crisis is now spreading rapidly to other capital markets both in the US and abroad. As David Rosenberg, economist for Merrill Lynch, declared this past fall: â€œThis has never happened before over such a short timeframe and this is rather seriousâ€¦â€?
The article will therefore examine the subprime mortgage meltdown from its apparent origins in 2002-03, but also from the perspective of its deeper origins dating from the aftermath of the Long Term Capital Management hedge fund bust of 1998. It will describe the more general financial crisis that lies behind the subprime symptom. It will then discuss the likely evolution of the financial crisis going forward into 2008-09, including its possible impact on the real economy, the inevitability of recession in the US, and the further potential for a deep depression globally.
Mainstream economists are largely content to describe the current financial crisis superficially, analyzing appearances rather than fundamentals. At best, their analyses reduce to assessments of the effectiveness of monetary policies (discount vs. federal funds interest rates, money supply-open market operations, reserve requirement adjustments, lender of last resort actions) undertaken in reaction to the crisis. Their common assumption is that the crisis is a matter of insufficient liquidity that can be solved with additional injections of money supply by central banks, especially the US Federal Reserve (FRB), European Central Bank (ECB), and Bank of England (BoE). However, as will be argued in more depth shortly, the current crisis is less a liquidity crisis than a more serious solvency crisis, which has already begun to spread from the core investment and commercial banks of Europe-North America to other capital markets, threatens to envelop non-financial corporate sectors in the wake of the inevitable defaults coming, and, should a significant recession occur in the U.S., may eventually migrate to the presumed immune emerging markets of China and elsewhere. As Bill Gross, the founder of the multi-billion dollar fixed income fund, PIMCO, declared in late 2007: â€œWhat we are witnessing is essentially the breakdown of our modern day banking systemâ€¦â€?
Revisiting the previous metaphor, as Federal Reserve and European Central Bank doctors, Bernanke and Trichet, today feverishly work on the seriously ill patient, injecting it with the insulin of money supply, the global financial systemâ€™s physiology may demand more than the good doctors might be able in fact to supply. Indeed, as of year end 2007 the capitalist medical money team is still searching for the correct diagnosis and the system may yet still need to be placed on temporary dialysis.
For Central Banks, even when acting in concertâ€”which has not always been the case to dateâ€”are not structured, authorized, or funded to play a true â€˜lender of last resortâ€™ role in a generalized solvency crisis. This article begins therefore with the assumption the current financial crisis is not a liquidity but a solvency crisis and that essential institutions do not exist to address a global solvency crisis effectivelyâ€”notwithstanding recent efforts by the major central banks and offshore sovereign wealth funds to provide the necessary money transfusion. The probability of global financial crisis deepening and spreading in 2008-09 is therefore relatively high.
In Part II the current financial crisis will be considered from a broader theoretical perspective. A description of the crisisâ€™s surface events, beginning with the subprime debacle and subsequently considering other capital markets, is necessary but not sufficient to understand the general evolution of the current crisis. A more theoretical approach is required which considers the current financial crisis in relation to prior similar events since the 1970s and asks how the present is different from that recent past. More specifically, how is it similar or different from 1929-1933 and other deep depressions. If the present event is not fundamentally different from past financial crises, it can be assumed the final outcome will be similar to other financial crises that have occurred from 1970 through 2000 and that the current financial crisis will be eventually successfully contained; if the present event is more similar to 1929-1933 in its fundamentals, however, then presumably a deep global downturn is more probable.
As an initial effort toward such a theoretical analysis, the article will review the theory of financial crises as proposed by perhaps the best known theorist of financial crises, the post-Keynesian economist Hyman Minsky. (2)
(2)Other innovative theoretical perspectives on causes of financial cycles will of necessity remain unaddressed in the paper, to be taken up at a later date in another paper. These include the works of J. M. Keynes and Irving Fisher, upon whom Minsky drew significantly for his views. Other economists include Michael Kalecki and Joseph Steindl, as well as various marginally mainstream economists (heterodox, structuralist, and post-Keynesian) of the past few decades who have also been addressing the subject of financial crises and cycles.
The essential elements of Minskyâ€™s â€˜financial instability hypothesisâ€™ will be described. Minskyâ€™s perspective offers the best view to date as to the dynamics and internal processes that underlay recurrent financial crises in the postwar period. However, it will be further argued that Minsky does not adequately explain the inter-relationships in terms of profit determination between the real and financial sectors. And while Minsky acknowledges the possibility, he does not adequately explain the process by which cycles in the real and financial sectors at times converge, mutually reinforce, and subsequently together lead to a deep global depression. Transmission mechanisms between real and the financial sector cycles thus require further clarification beyond what Minskyâ€™s work has provided.
Part III will briefly consider another possible theoretical approach toward explaining financial crises: Marx â€˜s views with regard to the circulation of capital as set forth in volumes II and III of Capital. Marx developed no integrated theory of financial cycles but rather suggests some potential approaches in his more general assessment of capitalist crises. His theory of general capitalist crisis at times refers to disproportionalities between constant and variable capital (i.e. the organic composition of capital), critiques what are called realization crises (insufficient consumption to absorb overproduction), or cites the potential for crisis inherent in a capitalist economy due to the tendency of the aggregate rate of profit to fall.
However, in terms of an analysis of financial crises Marx basically adhered to a 19th century transactions demand for money, viewing money as a largely passive conduit for the transformation of capital from one form to another formâ€”at least such is the case in Vol. 1 of Capital in the form of that volumeâ€™s well known C â€“ M â€“ Câ€™ equation. The banking system provides money and finance for purposes of capital accumulation (investment) either from internal funds or via bank debt. In Vol. II of Capital, however, Marx began to consider a more sophisticated concept of money, envisioning a role beyond its basic transactions function and presaging its use in more speculative situations. There he began to speak of â€˜money hoardingâ€™ as well as to raise the possibility of various commodity forms of money. Money may be used to invest in and accumulate physical goods/assets but money may also be used to invest in money and financial assets. These ideas were never fully developed to the point of publication by Marx. But expanding the idea of disproportionality analysis, which lies at the core of Marxâ€™s concept of the organic composition of capital, as well as considering the role of various new money forms of capital within such an analysis, is a potential undeveloped in Marxâ€™s Vol. II which represents fertile ground for the further extension of his general analysis of capitalist cycles and crises.
Consequently in Part III, as a means of improving the analysis of financial crisis using traditional Marxist terms, the article will begin to explore the idea of developing the concept of the organic composition of capital beyond its historically limited focus on physical forms of capital (constant and variable), adding commodity money forms as equivalent forms of capital alongside the traditional physical forms. In other words, an expanded disportionality analysis may represent a potential new approach to better understand cyclical crises in general, and financial crises in particular, in a 21st century capitalist economy.
In addition to expanding the idea of the organic composition of capital to facilitate the analysis of financial crises, the article will raise the suggestion that Marxâ€™s notion of the tendency of the rate of profit to fall should also be reexamined to better account for money forms of capital and financial crises. The controlling idea of profits might then become not simply the tendency of the aggregate rate of profit to fall, but the tendency of profit to fall due to the development, over the course of long term business cycles, of significant relative disproportionalities in profitability between the financial and real sectors of the economy.
The reader should note, however, that the above considerations of both Minsky and Marx in relation to understanding financial crises and cycles represent only initial exploratory efforts by this writer. In both cases the emphasis will be on defining future directions of analysis to be yet undertaken. It is the writerâ€™s firm belief, however, that in the 21st century capitalist economy Finance Capital has become the dominant, driving force determining the cyclical movement of capital in general. Furthermore, cyclical downturns that occasionally lead to deep global depressions are the consequence of the degree of congruence of relatively longer term financial cycles with shorter term, more frequent, real cycles. Converging oscillations of real and financial cycles not only exacerbate the general downturn of both, but render traditional institutions and policy measures ineffective in countering the general downturn. The key to understanding the occasional emergence of deep global depressions therefore lies in better comprehending the interdependency and relativity of investment and profit rates between the real and financial sectors of the capitalist economy.
PART I: Origins and Dimensions of the Current Financial Crisis
At the heart of both the subprime meltdown and the broader financial crisis today is the deregulation of finance capital and the resultant multiplying of new commodity forms of money and credit over the past several decades. This process of spawning new forms has resulted in a proliferation of new credit instruments and financial institutions associated with those instruments. The process, moreover, has been accelerating with the last decade in particular, producing a virtual financial buffet of finance-related acronyms: CDO, CBO, CLO, SIV, CDS, CPDO, CMBS, ABCPâ€”to name but the more commonly referenced in the public press.
Underlying this process, forms, instruments, and their corresponding new institutional forms is the common development of what is called â€˜derivativesâ€™. Derivatives involve the fictitious development of financial asset products offered for sale to investors, private and corporate. They have no intrinsic value. They â€˜deriveâ€™ their value from other real assets. They are financial products for sale that are â€˜derivedâ€™ from other financial products. They have virtually no â€˜cost of productionâ€™. Their costs of distribution and sale are essentially non-existent. And their market price is largely the outcome of speculative demand and, to a lesser extent, how fast financial institutions can create the original financial assets (e.g. mortgage loans) on which the derivatives are then in turn developed. Moreover, derivatives can be created on top of derivatives, in an unlimited pyramid of speculative financial offerings. Like a house of cards, the offerings may be stacked upon each other, until such time as one of the cards slips out of place bringing the rest down with it.
In todayâ€™s global economy there are more than $500 trillion in derivative outstanding. That compares to a global annual gross domestic product for all the nations of the world of less than $50 trillion. And to the U.S. annual GDP of approximately $13 trillion. In other words, there are now more than ten times in derivative contracts than all the real goods and services produced by all economies in the world annually. The worldâ€™s wealthiest investor, Warren Buffet, has called derivatives â€œtime bombs both for the parties that deal in them and the economic systemâ€?. They represent, according to Buffet, â€œfinancial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethalâ€?.
The Subprime-CDO Derivative Nexus
Subprime mortgages represent one relatively small â€˜land mineâ€™ in the panoply of â€˜financial weapons of mass destructionâ€™ described by Buffet. Subprimes are an essential element of just one example of super speculative investment built upon one form of derivative called a CDO, a â€˜collateralized debt obligationâ€™. Subprime mortgages lay at the foundation of the CDOâ€™s derivative pyramid. The mortgages themselves represent the value of a real assetâ€”i.e. the housing product on which the mortgage is based. The mortgages are then packaged into the fictitious financial asset package, called the CDO, which is then in turn marked up by the financial institution which sells the CDO to wealthy investors, hedge funds, other funds, or corporations. The mortgages themselves are not packaged in original form in the CDO, but instead are broken up, i.e. divided into â€˜slicesâ€™ that may be distributed across various CDOs. Only parts of any given subprime mortgage may thus reside in any given CDO offering. Since only parts of a subprime mortgage may be included in a given CDO, parts of other assets are typically â€˜sausagedâ€™ into the same CDO alongside the subprime â€˜sliceâ€™ as well. These other assets may themselves be fictitious in character (i.e. not based on any real physical asset), or may be based upon some real assetâ€”for example Commercial Paper issued by some real company to raise funds to carry on or expand its real business. Or a loan issued by a bank backed by real collateral (e.g. a Collateralized Loan Obligation, or CLO). But other forms of fictitious assets may also be bundled for mark up in the given CDO, alongside the subprime slice or Commercial Paper of company â€˜xâ€™. These may include fictitious â€˜securitiesâ€™ issued based on expectations of future ticket sales for sports events, a rock starâ€™s future concert royalties, or even more absurd examples of so-called â€˜bondsâ€™.
Not all CDOs of course have subprime mortgages bundled within their packaged market offering. Some may have slices of higher grade mortgages, or what are called â€˜Alt-Aâ€™ mortgages. Or they may have both. Many CDOs also include what are called Asset Backed Commercial Paper (ABCP). Many companies with doubtful performance and future prospects unable to raise capital more economically from other sources have entered the ABCP market in recent years to raise cash to stave off default by entering that market. Their â€˜commercial paperâ€™ is then bundled with a CDO and offered to market. Thus shaky subprime mortgages may be packaged with equally shaky corporate commercial paper.
But the banks and other institutions that eventually sell the CDOs were, at least until the recent crisis began to appear in late summer 2007, not all that concerned about the quality of their derivative-CDOs. Their relative unconcern flowed from their ability to buy â€˜insuranceâ€™ for the CDO, in the form of yet another derivative called a â€˜Credit Debt Swapâ€™ or CDS. Yet another means by which banks attempted to insulate themselves from the shaky quality of speculative investments has been their creation of the new institution called the SIV, or â€˜Secured Investment Vehiclesâ€™. SIVs are bank-created electronic institutions set up â€˜off balance sheetâ€™ from the original bank. They are in essence electronic shadow banks set up by investment and commercial banks like Morgan Stanley, Bear Stearns, Citigroup, Bank of America (and virtually every known national or regional major bank in the U.S.) to offload potentially risky CDOs from the banksâ€™ balance sheets, where bank record keeping is subject by law to review by the US Securities and Exchange Commission. With SIVs typically quickly â€˜turning overâ€™, or selling, the CDOs to hedge funds and other wealthy investors and corporations, a third â€˜safety valveâ€™ presumably existed.
Subprime mortgages, bundled within CDOs, issued by SIVs, and held off balance sheet by the big banks represent a highly profitable enterprise for the banks. First, the banks make money from fees issuing the CDO. Second, they are able to offload assets from their bank balance sheets thereby both reducing capital carrying costs as well as making available more bank reserves for loaning out at interest. Third, their SIVs make money from marking up and selling the CDOs as well as from insuring them at an additional charge with credit debt swaps. It is therefore not surprising that mainline investment and commercial banks experienced compound profits growth of more than 20% per year collectively for each year from 2004 through 2006â€”i.e. roughly the period of the most explosive growth of subprime mortgages bundled with CDOs.
The above scenario is sometimes referred to as an example of the so-called â€˜securitizationâ€™ revolution in finance. Securitization is the process of assembling assets on which new securities are issued and then sold to investors who are (in theory) paid from the income flow created by the assets. The more risky the assets contained within the CDOs, the lower the credit ratings but the higher the potential return. The justification for the highly speculative and high risk character of the offerings is that by â€˜slicingâ€™ the CDOs into tranches, based on the degree of risk in the assets in the given CDO, the more that the risk would be dispersed among a large population of investors. In reality, however, the result was the dispersion of contagion not dispersion of risk from the risky investments.
This â€˜securitization revolutionâ€™ is largely a product of the post 1998 period. In 1998 the total international volume of securitized offerings amounted to less than $100 billion. By 2003 it had risen only to $200 billion. By 2003 to more than $320 billion, more than $500 billion in 2005, and exceeded $1 trillion in 2006.
Bursting the Subprime-CDO Bubble
Business press pundits repeatedly query about how is it that so many subprime mortgages were issued to home buyers who clearly could not qualify for mortgage loans on any reasonable criteria, or who would obviously be unable to make payments on their mortgages once interest rates inevitably rose to normal levels. What the pundits donâ€™t understand is that, given the increasingly trend over time toward a greater relative mix of speculative to total investment arrangements in the 21st century capitalist economy, it is quantity, not quality, of investment opportunity that takes precedence. Since 2003 the practice of the banks had been to encourage mortgage loan companies to produce more loans regardless of the quality of those loans. Mortgage loan companies in turn provided incentives to real estate brokers to deliver more loans without consideration of quality. And real estate brokers, like the good used car salesmen they are, said whatever was necessary to close the deal with the home buyers.
In other words, the faster and easier it became to crank out a larger volume of mortgage loans the greater the volume of CDOs and related derivatives that could be packaged and marked up at profit by the banks and their â€˜shadow banksâ€™, the SIVs. No matter if the total volume of mortgage loans by 2005-06 were more subprime than not. The quantity of loans, not their quality now mattered most. And even quantity was only part of the new profit model. Finance profitability in 21st century finance capitalism was becoming less and less dependent on the issuance of loans per se, but increasingly on the edifice of derivatives and their supporting institutions built upon loans and their assets.
The U.S. subprime mortgage market accelerated in 2003-04. By 2005 more than $635 billion of subprime loans were issued. In 2006 the amount was another $600 billion. The cumulative total by 2007 was more than $1 trillion in subprime loans.
By mid-2006 it had become quite clear that the subprime mortgage market was in freefall. Home buyers with subprime mortgages were now defaulting on payments at record rates and foreclosures were beginning to rise. By late summer 2007 it was estimated that there were 2 to 3 million potential foreclosures over the next few years. The value of subprime mortgages quickly plummeted, and with them many of those CDOs in which they were imbedded. The subprime mortgage market virtually shutdown. It was not possible to accurately estimate the magnitude of the losses from the subprimes since they were â€˜slicedâ€™ and distributed within different CDO offerings. And if the losses for the subprime elements in CDOs could not be accurately valued, so too was it not possible for the CDOs to be accurately valued. Nor could the asset-backed commercial paper often bundled with the CDOs. And so on.
The typical response of investors in such situations is to ask how much their investments were â€˜under waterâ€™. And when they could not be accurately told, their next response is â€˜sell my investment and give me the cash remainingâ€™. But with no markets for subprimes by late 2007 their remaining value was impossible to estimate. No sales mean no price mean no possible valuation estimate and in turn no cash out possible. Investors, like the banks and their SIVs, were thus together locked in many cases in a death spiral, unable even to bail out and destined to ride the doomed vehicle into the ground.
By late 2007 various estimates place the value of expected losses from the subprime market collapse range from Goldman Sachsâ€™ low of $211 billion, to the OECDâ€™s estimate of $300 billion, to estimates based on the ABX Index, the official measure of subprime mortgage securitiesâ€™ value, which by late November 2007, estimated losses for the market at approximately $400 billion. In stark contrast to these estimates, however, the losses admitted by the major banks as of year end 2007 amounted to only a paltry $60 billion total. More, indeed, much more in terms of bank losses and bank write-downs due to the subprime market meltdown are yet to come in 2008.
But subprime losses and write-downs on bank balance sheets wereâ€”and still remainâ€”only part of the bigger picture and potential financial crisis.
Spreading the Subprime-CDO Pain
The estimated total volume of all CDOs worldwide (not all of which have subprime mortgages bundled with them) is, according to the OECD, approximately $3 trillion in total value. Approximately half that total is held by hedge funds, a fourth by banks, and the remaining exposure by asset managers and insurers. CDOs with subprime mortgage slices are only part of this much larger picture.
As noted previously, many of CDOs also bundled Commercial Paperâ€”sometimes with subprimes and often without. But asset backed commercial paper appears equally at risk as subprime mortgages and the consequences of its collapsed are yet to be fully realized.
Like the subprime mortgage market, the ABCP market experienced a sharp runup between 2003-07 in conjunction with the acceleration of CDOs and other derivatives. Many companies in trouble financially and unable to raise capital to continue, or only able to do so at great expense elsewhere, turned to the ABCP to issue commercial paper on their remaining real assets to raise cash for operations or investment purposes. Much of their risky commercial paper was bundled with CDOs. But like the subprime market the ABCP market has virtually shut down as well since the advent of the financial crisis in late summer 2007. The ABCP market in the U.S. peaked at $1.2 trillion in August 2007 and had fallen to $700 billion by year end. By June 2008 an additional $300 billion is projected to come due. Thatâ€™s another $300 billion banks may have to provide for on their balance sheets, in addition to the $400 billion in additional subprimes coming due. In Europe the commercial paper market is also declining rapidly, having fallen 44% by October 2007 to $172 billion from a May 2007 peak of $308 billion.
With the ABCP market largely shutting down, many corporations straining to stay in business in recent years by selling their commercial paper in that market will likely now begin to default. That means a sharp rise in business bankruptcies. For example, nonfarm business debt rose by 30% in 2004 and continued thereafter at levels greater than the historical average. Many CDOs with embedded commercial paper helped hold off defaults and failures between 2003-07. But with the shutdown of the ABCP markets, the built up pressures for corporate defaults will be released with the consequent result of sharp increases in corporate bankruptcies in 2008-09. The corporate ratings agency, Moodyâ€™s, in fact predicts an increase in default fates between four and ten times the most recent rate in the period immediately ahead, and the highest since the peak fallout from the dotcom bust in 2002.
Together, general loans to business and commercial paper are two capital markets which companies most heavily rely upon to finance their short term business operations. The two combined had a total of $3.3 trillion in outstanding credit to businesses in August 2007. However, in a matter of only three months, total loans had fallen by more than $300 billion. There is no way such a rapid contraction of credit could avoid a sharp drop off in general business investment and a recession. In fact, a much smaller percentage decline of business loans from these two sources immediately preceded the last two recessions in the U.S.
Even more worrisome, it appears in recent months that other capital markets are now being increasingly affected by the growing generalization of the financial crisis beyond the subprime mortgage and commercial paper markets.
To briefly review some select examples:
It appears the collapse of the residential mortgage markets have begun to spill over to the commercial property market as well. After peaking at $131 billion for the month of June, 2007, the issuance of commercial property mortgage loans had declined to only $8.6 billion in October 2007. With more than $3 trillion in commercial mortgages outstanding in the U.S., estimates in the business press are that $212 billion in commercial property loans are currently at risk of default. The investment bank, J.P. Morgan, alone expects $52 billion of write-downs in 2008 for the market, according to the same sources. Commercial property mortgages are expected to drop 73% in 2008 compared to 2007. The median price for homes in the U.S. has declined for the first time since the 1930s in the U.S. In short, the U.S. construction marketâ€”residential and commercialâ€”at year end 2007 is in a state of near free-fall.
In yet other areas, prices have begun to fall significantly in the bank-based money market funds and in the $2.5 trillion municipal bond markets, reflecting sharply declining demand for funds in those markets as well.
On the consumer side, auto loan delinquencies have risen in recent months to their highest levels since 1991, with the largest increase in eight years recorded for top rated borrowers, while the $100 billion a year student loan market recorded a 22% increase in default claims in 2007. Should a major retrenchment of stock markets occur in 2008, which is highly likely, related â€˜wealth effectsâ€™ will almost certainly reduce consumer spending even further and more rapidly. Consumer spending has been maintained over the past two decades not as a consequence of gains in pay and income for the 90 million non-supervisory wage earners in the US labor force, but as a result of three developments temporary in character which are now coming to an end. First has been the major growth in hours worked per working class family in the US, averaging about 500 hours per work year. Second has been the historic record growth in consumer debt, in particular since 2000. Third has been the refinancing of homes and living off future assets to pay for large expenditures like medical care, kids education, cars and the like. The current financial crisis has abruptly ended the third. The recession will effectively eliminate the first. Only continued expansion of consumer credit remains as a remaining obstacle to a deep decline in consumption spending.
Given the magnitudes and dispersion of the current credit and loan contraction, and its inevitable lagged effect on consumer spending, it is virtually impossible to presume that the U.S. economy is not headed toward a major recession in 2008. All that remains is government fiscal and monetary policy. But, as will be shortly explained, that too is serious constrained in the present financial, and soon emerging real, crisis.
The emerging, severe contraction in business credit and investment does not appear limited to the U.S. economy. Although markets and economies elsewhere appear to be lagging US events, nonetheless the general asset bubble appears to have begun to bust globally as well.
According to the U.K. business press source, the Financial Times, global total debt issuance in the first half of 2007 peaked at a total of $3.960 trillion in bonds sold worldwide for the first six months of the year. Estimates for the second half of the year are for totals at about half that, at $2.06 trillion. The global structured finance (i.e. SIV-like) market recorded totals of $1.57 trillion in the first half of the year, now down to only $.56 trillion in the second half. Similarly, the two lower tiers of the bond market, comprised of junk bonds at the lowest and high yield corporate bonds at the mid-level, fell from $1.02 trillion to $270 billion over the same recent periods. Only the highest tier, investment grade bonds has recorded growth in 2007. (3)
This scenario of deep and accelerating credit contraction, still rising volumes of non-performing loans, continued growing pressures on bank and other financial institutionsâ€™ balance sheets, prospects of rising corporate defaults, and signs of consumer stress on big ticket durable purchases all point to a convergence of financial and real economic conditions unlike that accompanying other identifiable â€˜financial crisesâ€™ since 1970. It is virtually assured the outcome will be recession in the U.S. And the chances of the cycle spreading elsewhere and becoming synchronized across major national economies is at present in excess of 50-50.
(3) Financial Times, December 21, 2007.
Some Similarities & Differences in Financial Crises Since 1970
An important defining characteristic of the current financial crisis is the speed at which it has been transmitted, both within markets in the US and from the US to markets abroad
as well. U.K. and German banks, Australian municipalities, Canadian commercial paper marketsâ€”all show the close interaction and mutual dependencies of financial markets today. This speed of transmission has been due, in large part, to the nature of speculative investment itself, based increasingly on derivative and derivative-related instruments that can be packaged, bought and sold electronically in an instant. It is also a result of the state of near-complete deregulation of financial markets; the deep opacity of new financial instruments and institutions, increasingly shielded from traditional governmental oversight; and the proliferation of new forms of commodity money and institutions from hedge funds to SIVs. Since the mid-1990s these three characteristics of the current crisis have evolved to an extreme in the U.S.
Hedge funds, private equity firms, structured investment vehicles, off balance sheet financing, Basel I (and soon II) international banking agreements, the repeal of 1930s bank regulations under Reagan in the 1980s and the last vestiges of financial regulation under Clinton in the 1990s, U.S. federal intervention to prevent states from investigating questionable bank practices under George W. Bushâ€”all add up to a bright green light signaling finance capital to push the speculative investment envelop as far and as fast as they like.
Prior financial crises in the U.S. were not characterized to such a degree of deregulation, opacity, or proliferation of forms of money capital. Even the experience of 1988-1992 and 1982-83 in the U.S. does not compare. The Savings & Loan crisis, junk bonds and the stock market crash of the late 1980s pale in comparison to present developments. They are not the same animal by any reasonable measure. While events in the 1970s (Penn Central, Franklin National, Lockheed, Chrysler) were essentially isolated occurrences involving companies which threatened to upend select capital markets but were quickly identified and contained. Nor did the events occur during a convergence of cycles. The financial and real cycles were sequential, not convergent.
Prior to the mid 1990s there were also no significant derivative markets to speak of,. There were still vestiges of regulation and oversight. Off balance sheet financing constituted fraud and justified jail sentences. And both fiscal and monetary policies still retained a degree of effectiveness in dealing with what were essentially short-term and contained liquidity crises. The present financial crisis, however, is not about liquidity but increasing about solvency. It is about basic confidence in the banking system itself. It is about the convergence of real and financial downturns, threatening to synchronize on a worldwide scale.
Another notable characteristic of the present crisis is that it is occurring in an environment of seriously compromised government policyâ€”at least in the U.S.
It is interesting that more has not been written about the massive injection of money supply that occurred in the wake the Long Term Capital Management (LTCM) debacle of 1998 to 2005. LTCM was rescued in part by the Federal Reserve injecting liquidity into the economy. It was followed by the Y2K event and further monetary stimulus, followed in turn by the dotcom bust of 2000 and still further stimulus, followed in turn by 9/11 and more stimulus. The cumulative result was interest rates driven down to 1-2% by 2002-03 and in turn the consequent subprime mortgage asset price boom.
Even more interesting, however, is the degree to which strongly expansionary monetary policy in the US produced a relatively weak recovery in the real economy (apart from the housing market) in the US following the 2001 recession.
In the real economy, it took a full 48 months for job levels to recover to original levels in 2001 just prior to that recession. This fact suggests that much of the monetary stimulus of the years 1997-2002 was siphoned off into speculative, rather than real, investment activity. Or that the historically loose monetary policy served to stimulate real foreign direct investment by US companies in offshore markets instead of in the US home market. Or that the liquidity was simply redirected by wealthy US and corporate investors to offshore tax shelters, from the Cayman Islands to Vanuatu. (These shelters, by the way, increased their reported assets from $250 billion in the 1980s to more than $7 trillion by 2005, according to Morgan Stanley research). Or perhaps all three effects.
Whichever of the three effects, the rapid and unregulated change in the financial structure since the mid-1990s resulted in the diversion of increasing amounts of credit and capital into forms of speculative in lieu of real investment. This no doubt explains, at least in part, the tepid real economic growth in the US economy post-2001(not to be confused with GDP growth which factors in much of the speculative investment activity into US national account calculations). It further helps to explain as well the four year long lag in real job recovery and the relatively slow recovery of profits for companies that were not multinational or not located in the service or financial sector.
The advent of over-expansion monetary policy in the wake of the LTCM crisis of 1998 suggests that the current financial crisis may be best viewed as a continuum from that event to the present. The last vestiges of banking deregulation, the acceleration of derivatives markets, the proliferation of new money commodity forms, and the steady unrelenting injection of liquidity into the economy all more or less extend from the 1997-99 period. As speculative pressures built up they were temporarily addressed and contained, making for a subsequent period of even greater pressure. LTCM gave way to Y2K, followed by the dotcom bust, and the 2001 recession that was cut short by major further injection of money and accelerating fiscal spending in the wake of 9-11. The corporate default fall-out from the dotcom bust were just being absorbed in 2002 when conditions were simultaneously being laid for the subprime mortgage boom. Just how much pressures had built up by 2005 is evident by how little interest rates had to be raised in 2005-06 in order to provoke the beginning of the collapse of the subprime boom and how quickly that boom unraveled. Thus the roots of the current financial crisis are best located in the events and conditions of 1997-99 and not simply in 2003 and after.
While excessively stimulative monetary policy failed to generate the level of investment in the real economy that might have been expected, so too has fiscal policy since 2001. More than $4 trillion in tax cuts were passed during George W. Bushâ€™s first term alone, with hundreds of billions more in 2005. On the fiscal side they were accompanied by an ever-growing defense expenditure budget that has grown progressively since 2001 and now approximates $1 trillion a year when all departments, not just the Pentagon, are factored into the calculations. Thatâ€™s trillions in both tax cuts and defense spending which should also have had a major impact on US real sector growth but didnâ€™t. When combined with the expansionary monetary policy, the combined fiscal-monetary effects should have produced real sector growth of at least 6% to 7% each year for 304 consecutive years. But they didnâ€™t.
As with the monetary policy, a credible argument can be made that the fiscal stimulus was also redirected offshore. Nearly 80% of the tax cuts accrued to the wealthiest households and corporations, fueling offshore emerging market investments, offshore hedge fund growth, tax avoidance, and record levels of corporate offshore retained earnings. Once again, US based real investment and consequent jobs and income growth for wage earners benefited little from the â€˜structureâ€™ of fiscal as well as monetary policy since 2000. What did benefit significantly were those who could and did engage increasingly in speculative investment opportunities. Like the monetary, the misdirected fiscal excesses since 2001 have rendered policy largely compromised and therefore likely ineffective as the current financial crisis deepens.
From Financial to Real Cyclical Downturn in 2008
The speed and dispersion of the current financial crisis have been, as previously noted, unique characteristics. That speed and dispersion may also accelerate the transmission of the financial crisis to the real economy.
The scope and magnitude to date of the credit contraction is also an important factor. Not just subprime mortgage markets but commercial property, commercial paper, the junk and high yield corporate bond sectors, and other capital markets are all showing evidence at year end 2007 of contraction. Pending corporate defaults and signs of weakening consumer spending in auto loans and other durables are additional evidence of the spread from the financial sector to the real economy in the U.S.
Other potential â€˜shockâ€™ events in the months ahead may also hasten the transmission from the financial to the real sector.
For example, the bankruptcy of one or major commercial or investment banks and their forced consolidation with other banks would certainly have a significant effect on remaining investment and even consumption spending. In fact, a major bank failure in 2008 is not unlikely. As previously noted, major U.S. banks have reported losses and write downs thus far of barely $60 billion. But various credible sources project losses in the subprime market alone at $400 billion.. Then thereâ€™s the estimated $212 billion losses projected for the commercial property market, and the $300 billion in the ABCP market. That still leaves the impact of corporate defaults and postponed private equity deals. The central banks, either individually or even collectively, are not structured to address that kind of solvency and balance sheet shortfall.
Some more sanguine analysts maintain that foreign sovereign wealth funds may â€˜ride in on the white horseâ€™ and bail out the banks. But donâ€™t count on it. They too may balk at the scope and magnitude of the crisis, or at best selectively pick and choose the best deals, i.e. the low-hanging bank fruit, leaving the majority on the tree to rot. More likely, should the solvency crisis deepen it will require coordinated, major cross-industry government â€˜financial nationalizationsâ€™. This is exactly what happened during the 1929-1933 deep depression. The central banks played minor roles, including the Federal Reserve. Special government entities, like as the Reconstruction Finance Corp. in the U.S., were created on an ad hoc, emergency basis to bail out the banking system.
Looming large on the horizon in 2008 is also the prospect of a major retreat of the US and other stock markets. That has not happened yet. But less severe financial crises in the 1970s and 1980s were followed by major stock market contractions. The contraction associated with the current crisis is still to take place. When it happens, however, the accompanying â€˜wealth effectâ€™ will certainly reduce consumption still further, intensifying the transmission of the financial crisis to the real economy in turn.
The bankrupting of one or more major hedge funds may also have an effect. Or the eventual retreat of investments in emerging market economies as recession deepens in the U.S. That would also include China. The slowdown in spending in the US and its impact on emerging markets and China should not be underestimated. And China cannot and will not play consumer of last resort to the rest of the capitalist world.
Both the data trends and the likelihood of one or more of the above â€˜shockâ€™ events occurring in 2008 are thus highly probable. It is not only virtually ensured that recession will occur in the US in 2008, but that the transmission of the financial crisis to the real economy in the US may in fact occur faster and go deeper than predicted. Nor is the spread of the downturn, both financial and real, to other sectors of the global economy ruled out as well.
PART II: Minskyâ€™s â€˜Financial Instability Hypothesisâ€™
Contrary to most mainstream economists, Hyman Minsky maintained that financial instability was endogenous (i.e. intrinsic) to capitalist economies and not due to â€˜externalâ€™ shocks to the system. He believed that financial pressures tended to build within capitalist economic systems over the course of a long cycle. These pressures might be â€˜relievedâ€™ temporarily by successful central bank intervention, and monetary policy might be employed successfully to prevent the spread of a liquidity crisis. However, under certain conditions and at timesâ€”as in 1929-1933â€”traditional monetary policy might prove ineffective. Pressures that had been built up over successive crises and prior resolutions of those crises might not be easily contained at some point over the long run. The outcome would then be an event similar to a deep depression, such as occurred in the 1930s.
The potential for containing a financial crisis depended on the degree and relative weight of speculative investment in the economy, according to Minsky. He maintained there were three basic forms of finance regimes with fundamentally different cash flow to debt relationships. The first is what he called â€˜hedge financingâ€™ (not to be confused in any way with hedge funds). Hedge financing was simply traditional financing of investment projects in a way in which liabilities associated with the investment were eventually repaid out of future cash flow from the investment. The second form is what he called â€˜speculative financingâ€™. This is where interest on debt might be paid from cash flow but principle was not. This payment shortfall led to the eventual need to issue new debt to refinance the old principle. The third category of financing was called â€˜ponzi financingâ€™, so named after the famous investor of the early 1920s, Ponzi, who essentially marketed pyramid schemes to unsuspecting investors. According to Minsky, ponzi finance was characterized by no intent to pay either principle or interest from cash flow. In ponzi finance, the intent is to make payments by borrowing or by selling assets.
Speculative and ponzi investment regimes do not generate sufficient internal cash flow from investment to enable the payment of full principle and interest, he suggests. Hence they resort to other solutions that essentially seek to bypass such payment. Speculative and ponzi investment also represent the accumulation of unpaid debt over time. Their tendency is thus to produce both less relative cash flow and add more relative accumulated debt, compared to traditional hedge financing. And when asset prices freefall the general income to debt ratios worsen further for speculative-ponzi regimes and financing units. With little internal cash flow generated from the investment by its very nature, the only recourse is forced liquidation of positions with speculative-ponzi investment.
Where hedge financing dominates the economy, according to Minsky, financial crises are either non-existent or relatively mild and thus infrequent and easily â€˜containedâ€™ by central bank policy. â€œIn contrast, the greater the weight of speculative and ponzi finance, the greater the likelihood that the economy is a deviation amplifying systemâ€?. (4)
Minsky repeatedly refers to both financial structures and financial relations that change dynamically over time. Over a protracted period of good times, he argues, capitalist economies tend to move from a financial structure dominated by hedge financing units to a structure where greater weight is given to speculative and ponzi finance. The tendency is also for speculative finance to migrate into forms of ponzi finance under conditions of asset price inflation. And under such inflationary conditions, ponzi finance units tend in turn to lose net worth and evaporate. â€œConsequently units with cash flow shortfalls will be forced to try to make positions by selling out position. This is likely to lead to a collapse of asset valuesâ€?. (5)
(4) H. Minsky, â€œThe Financial Instability Hypothesisâ€?, working paper # 74, May 1992
(5) H. Minsky, â€œLonger Waves in Financial Relations: Financial Factors in the More Severe Depressions II,
Journal of Economic Issues, March 1, 1995.
In Minskyâ€™s view, therefore, capitalist financial systems have an inherent long term tendency toward a greater composition of speculative and super-speculative (ponzi) investment, and in turn toward asset price booms and resultant asset price deflation and busts.
If left unchecked, the tendency to shift financial structure and relations toward speculative investment would eventually prevail, producing more frequent and more serious asset price boom-bust cycles. Internal â€˜constraining factorsâ€™ may hold back the trend, according to Minsky, with the result that asset price explosions from speculative activity intensifying tend not to occur. On the other hand, in an environment and economy heavily weighted with speculative-ponzi finance, and thus cash flow shortfalls and high debt to cash flow ratios, the containment barriers may be broken â€œso that a cumulative interactive debt deflation takes placeâ€?. (6) In such instances the financial structure, according to Minsky, has evolved from a â€˜robustâ€™ to a â€˜fragile financial structure.
A critical role by Minsky is thus given to both policy and institutional elements in checking and containing the tendency toward liquidity and solvency crises in the system. When constraints and policy interventions are effective, â€œthe endogenous process is stopped and restarted with initial conditions that reflect the constraints and the interventionsâ€?. (7)But what were once effective institutions at one point in time and place, may not be at a later time and place without updating and adjusting institutions and policies to accomodate new structures and relations. By implication Minsky seems to be saying that institutions like the Federal Reserve, deposit insurance, and the like may have been successful and sufficient at one point in time, but as financial structure and relations change so too must policies and institutions change in order to maintain effectiveness in checking the inherent evolution toward financial instability within the system.
Minsky of course could not foresee when he wrote the extent to which institutions and policies that once served to contain the inherent trend would be â€˜deregulatedâ€™ and effectively dismantled since 1980. But had he witnessed the full extent of current financial deregulation he would no doubt conclude it would lead to a greater weight of speculative-ponzi activity and thus significantly increase financial â€˜fragilityâ€™. Institutions and policies matter when it comes to constraining the systemâ€™s inherent tendency toward asset price booms and busts, financial fragility and financial crises. But instead of evolving and strengthening policies and institutions over time, as the financial structure has evolved, the actual practice in the U.S. in recent decades has been to dismantle those same policies and weaken those institutions.
When policies and institutional constraints are strong, financial cycles and crises occur in â€œtruncated or vestigial formsâ€? and institutions and policies â€œmay contain or offset the forces that make for financial panics and deep depression cyclesâ€?. (8) When those same constraints are lifted or weakened, however, presumably the opposite occurs and the tendency toward financial panics and deep depression cycles intensifies.
(6) (7)(8) Minsky, â€œLonger Waves..â€?
The foregoing in no way exhausts the full perspective of Minsky on financial instability However, critical comments may be nonetheless appropriate at this point.
First, Minsky in our view does not go far enough in explaining why financial structure and relations tend toward more speculative forms over time. Nor does he adequately explain the relationship of the growing fragility to the drive for profitability, despite having explicitly proclaimed the tendency toward financial fragility was â€œthe expected result of profit seeking activityâ€?. (9)
Why is it that investment shifts toward a more â€˜fragileâ€™ structure? The answer must certainly lay in the greater short term profitability of speculative investment. In Part I above the attempt was made to begin an explanation of this. Minsky refers to profitability in terms of cash flow generation and debt ratios but thatâ€™s as far as he takes it. And with virtually no cash flow for speculative-ponzi investment it would seem a contradiction to argue that greater profitability was the primary incentive underlying the shift toward speculative investment. But if speculative-ponzi investment is less profitable in terms of cash flow than hedge investment, it must then be explained why there occurs such a strong tendency toward speculative investment forms? Once again, what is the primary incentive and forces driving the shift toward more relative speculative investment? If itâ€™s profits, how so. If not profits, what else?
It is not only counter-intuitive but nonsensical to assume that the shift of investors toward more speculative forms has to do with anything but profitability. The greater profitability of speculative forms of investment must therefore reside, at least in part, in their virtually non-existent cost of goods and cost of sales product cost structure, a major profitability factor when compared with hedge investment in real physical assets which typically have high cost of goods and cost of sales. In addition, the â€˜electronic natureâ€™ and global character of speculative investment implies it is able to address a much larger potential market and a more immediately accessible market than hedge investment in physical assets.
The elimination of barriers in the form of deregulation of course provides yet another major incentive toward speculative investment. Other factors stimulating speculative investment, one suspects, are to be found in the various tax and trade policies of recent decades that provide significant direct incentives for undertaking speculative investment. Finally, technology and other productive forces must also be included in the mix of factors supporting the tendency toward greater speculative activity. It is difficult to imagine the spread of derivatives in their various forms today without digital technology, computing power, soft technology (financial modeling programs), and the internet.
Second, with the importance given to institutions and policies in checking or allowing the trend toward financial fragility, a deeper analysis of those institutions and policies would be in order. What kinds of institutions and policies today might be effective in preventing the kind of deep, destabilizing financial crisis now underway? Of course,
(9) H. Minsky, â€œFinancial Crises: Systemic or Idiosyncraticâ€?, working paper #51, April 1991
Minsky could not have answer that specific question since he wrote and lived in a period from the 1970s to the mid-1990s. But it seems both an institutional and a policy analyses are both necessary to develop his views further in relation to financial cycles and crises.
Third, there appears in Minskyâ€™s analysis little inter-relationship between forms of hedge financing and the more speculative-ponzi forms of financing. Or what is almost the same thing, between investment in physical assets and in financial assets. In Minskyâ€™s scenario the two are apparently mutually exclusive. On the other hand, in real life the profit rates between the three investment markets must of necessity be inter-dependent in critical ways, if for no other reason that both must compete for the same available credit at a given point in time.
Finally, Minskyâ€™s analysis implies strongly that financial cycles and real cycles are not necessarily congruent, that financial cycles may be longer than real economic cycles, but that the two at times may converge in some way, tending toward greater congruency and causing each to become more severe than otherwise in the absence of such convergence. However, Minsky does not follow up in any detail on these possibilities of cycle convergence and congruence. It would seem essential that in some way, mathematical or graphical, the relationship between financial and real cycles be described theoretically.
Notwithstanding the foregoing modest critiques of his views, Minskyâ€™s analyses contribute much toward a deeper understanding of the nature and evolution of financial structures, relations and cycles. In particular, the perspective that such cycles and related crises are endogeneous and internal to the system, the focus on the evolving of structures and relations in finance, the identification of the internal tendency toward speculative forms, the relationships between speculative forms and asset debt deflation, and the relative effectiveness vs. ineffectiveness of policies and institutions over time in checking and/or allowing financial crises and deep depressions are all areas in his work which deserve further consideration.
PART III: Adapting Marxist Categories to the Analysis of Financial Crises
Of the various Marxist categories and concepts, among the most fundamental is the notion of â€˜forces of productionâ€™. The concept (and the reality) reach across space and time, basic not only to the capitalist mode of production and capitalist production relations, but to all modes and their production relations. The concept of â€˜forces of productionâ€™ also lies at the core of Marxâ€™s â€˜higher levelâ€™, derived concepts of constant and variable capital, the organic composition of capital (hereafter OCK), and the tendency of the rate of profit (TRP hereafter) to fallâ€”all of which are at the root of his explanations of economic crises and cycles.
Central to the idea of the organic composition of capital, OCK, in Marx is the broad idea of technology as a force of production determining the OCK. It is technology and related forces that largely determine the ratio of constant to variable capital, upon which both the OCK and TRP in turn depend. As will be argued below, however, the concept of forces of productionâ€”and specifically technology as a force of productionâ€”plays a central role with regard to finance capital as well.
The familiar Marxist formula for the organic composition of capital is C / C+V. When integrated with the idea of surplus value, S, it becomes the base formula in turn for expressing the rate of profit, P, which can be expressed in the integrated formula,
P = S/ C+V. The latter in turn reduces to the more concise expression of P = Sâ€™ (1-q), (where q represents OCK, the organic composition of capital, alternatively expressed as C / C+V).
Holding these well-known Marxist categories and simple equations in mind for the moment, we can temporarily move at this point to a consideration of financial capital in its contemporary speculative forms. We will later return once again to the classic Marxist categories and explore how the twoâ€”classic Marxist categories (OCK, TRP) and new concepts expressing finance capital formsâ€”might be integrated into a combined set of new concepts and equations that account for the new realities of 21st century finance capital-dominated capitalist economic relations.
From Constant/Variable Capital to CMFs
It is important first to note that Marxâ€™s concept of the OCK in vol. I of Capital expresses relations between forms of real assets, or physical forms of capital, and not money forms of capital. Constant and variable capital are not commodity money forms of capital. They are forms of physical capital; that is real assets and products. Throughout Parts I and II of this article reference has repeatedly been made to commodity money forms (hereafter CMFs) of capital. It was argued that such forms now play a central role in 21st century, finance capital-dominated economic relations, cycles, and