posted March 4, 2009
Speculative Capital, Financial Crisis, and Emerging Epic Recession

After nearly eighteen months of the U.S. Treasury and Federal Reserve Bank throwing more than $3 trillion at banks and other financial intermediaries—and foreign central banks and institutions the equivalent of the equivalent of trillions $ more—the global financial crisis refuses to abate. After more than a year of historic liquidity injections into banks and non-bank financial institutions, instead of containment of the crisis the outcome has been the Banking Panic of 2008—an increasingly global event that as of November 2008 has yet to run its full course.

The Banking Panic of 2008 represents a qualitative shift in the character of the global financial crisis. Beginning with the collapse and bailout of the quasi-Government mortgage agencies, Fannie Mae and Freddie Mac, in the summer of 2008, financial instability accelerated quickly thereafter resulting in the collapse of one of the largest Investment Banks, Lehman Brothers, in September 2008. The collapse of Lehman, worth some $650 billion in assets, had widespread global repercussions. It precipitated a chain reaction collapse of other Investment Banks and financial institutions, requiring further immediate bailouts and rescues in turn. Within days of Lehman’s collapse, the insurance giant, AIG, was quickly ‘rescued’, initially at a cost of $85 but thereafter rising to $150 billion. Acquisitions of Merrill Lynch, Washington Mutual, and Wachovia banks were forced-arranged in quick succession. Other, less well publicized or known bailout and rescue operations were undertaken as well, most notably involving the Money Market Mutual Funds and Commercial Paper markets, numerous regional and community banks, mortgage lenders, commercial credit companies, and even non-financial corporations, while looming large on the horizon are further anticipated financial crises and bailouts involving States, municipalities, auto companies, and state and local government Pension Funds.

The progressive deepening of the financial crisis during its initial year and ‘first phase’—from the initial blow up of the subprime market in July 2007 to the collapse of Fannie Mae/Freddie Mac in July 2008—resulted in a steady contraction of the availability of credit to financial and non-financial institutions alike. However, with the banking panic of 2008, that steady contraction of credit transformed into a qualitatively more serious ‘credit crash’ after September 2008. The virtual freezing up of credit markets after September accelerated the transmission of the financial crisis from banks and financial institutions to the real, non-financial economy. The rapidity of the transmission to the real economy is still largely unacknowledged by policymakers.

The sheer magnitude of the financial crisis and credit contraction, its scope (increasingly global), and its rate of spread (to other markets, other sectors and other geographic regions of the world) translates into a similar extraordinary magnitude, scope and rate of contraction of the real economy as well. The worst financial instability and financial crisis since the Depression of the 1930s is now rapidly becoming the worst contraction of the real economy as well—or what this writer has called an ‘Epic Recession’. (1) Epic Recession is not yet a classic global depression. Nor is it a typical post-1945 moderate recession. It has characteristics of both. It is a hybrid state. An unstable condition. It must either return to a more typical moderate recession, or else evolve further toward a more classic depression—such as occurred in the 1920-30s, or on several occasions similarly in the 1830-40s, 1870s, or 1890s in the 19th century. More on its characteristics shortly.

In a number of interesting ways, the current Banking Panic of 2008 looks much like the banking crisis of 1930-31 in the U.S. That period too appeared at the time as neither a typical recession nor yet a bona fide depression. But, as history shows, it eventually led to waves of corporate and consumer defaults and to a more serious downturn of the real economy, which in turn resulted in a subsequent more severe banking and financial crisis in 1931-32 that did drive the world economy into global depression.

The historic question of the present is whether the recent Banking Panic of 2008 and the now clearly emerging global Epic Recession will be successfully ‘contained’ as a consequence of new coordinated efforts at financial stabilization by the U.S. and global community; or whether such efforts fall short and the U.S. and world economies descend into a still deeper financial crisis and more severe global depression?

The answer to that question requires a deeper understanding of the fundamental causes of the financial crisis that erupted in mid-2007 and has progressively deepened ever since. It also requires a better understanding how that crisis is now transmitting to the real economy, provoking a similarly more severe contraction of the real economy called Epic Recession.

The U.S. Treasury’s $2 Trillion Handout

The financial crisis is not, and never has been, a liquidity crisis. What it has been is a solvency crisis, and as that solvency crisis has dragged out and not been resolved it has increasingly transformed into a general crisis of confidence in the banking and financial system itself. Liquidity means banks and financial institutions have adequate assets but just don’t have them in liquid form to cover debts and depositors withdrawals. Insolvency means they don’t have assets of sufficient value in the first place. Enhancing liquidity can stabilize a crisis so long as asset values do not collapse faster than liquidity can be injected. However, if asset values continue to collapse, throwing liquidity to cover the collapse is like throwing money down a black hole. Temporary ‘catch ups’ inevitably result in further shortfalls, requiring still more liquidity injections. The spiral continues so long as the fundamental causes of the collapse of asset values are not addressed. This fundamental strategic error—throwing liquidity at a solvency crisis—is

(1) Jack Rasmus, ‘The Emerging Epic Recession’, Z Magazine, June 2008, pp. 38-42.

what has characterized the past year and half of the financial crisis. And it explains why
the crisis has not been contained, why as it has dragged on it has resulted in a more general crisis of confidence, why the delay in containment has been translating into an equally severe contraction of the real economy—an Epic Recession.

What the Banking Panic and bailouts represent is government authorities pursuing a strategy of boosting bank-financial institution liquidity, even when it has become abundantly clear after sixteen months that the fundamental strategy of liquidity boosting has failed to produce any notable results in terms of financial stabilization.

Nonetheless, the liquidity strategy has continued. The most notable example of throwing increasing amounts of liquidity at the banks has been the U.S. Treasury’s ‘Troubled Asset Relief Program’, or TARP, which passed Congress on September 21, 2008 and provided for $700 billion in taxpayer money. (2) To this amount must be added a prior $85 billion for the bailout of AIG, the American Insurance Group, the largest insurance company in the U.S., which was later increased to $150 billion;(3) a minimum of $200 billion more for the bailout of the quasi-government mortgage agencies, Fannie Mae and Freddie Mac, provided by the passage of the July 2008 housing act; (4) another $50 billion U.S. Treasury Secretary, Henry Paulson, admitted he ‘found’ in some heretofore ‘overlooked’ fund at the Treasury; plus yet undetermined tens of billions of dollars in new tax breaks the Treasury, immediately following TARP, ordered the Internal Revenue Service—the U.S. tax collecting authority which resides within the Treasury—to grant to the banks following the passage of TARP. (5) The total amounts to more than $1.2 trillion, an amount that will eventually be shifted from taxpayers to the banks and other financial intermediaries.

This $1.2 trillion does not include, however, $200 to $500 billion more that will soon be needed by the Federal Deposit Insurance Corporation, FDIC, to bail out anticipated defaults by hundreds of regional and community banks in the U.S. The FDIC’s assets on hand amount to only $35 billion or so. It is liable for 8400 banks with total liabilities of more than $13.3 trillion. Estimates are that as many as 117 such banks with more than $800 billion in liabilities are on the ‘watch list’ and are candidates for possible default and bankruptcy, requiring the FDIC to compensate depositors. Combined losses could be as high as $400 billion. (6) The FDIC’s recent bailout of the IndyMac bank alone required $8.9 billion of the FDIC’s assets.

But none of the above total includes funds for providing ‘incentives’ to mortgage companies and to renegotiate home loans with the three to five million or more U.S. homeowners expected to enter foreclosure over the next 12-18 months. That too is soon coming. Talk of re-setting mortgage rates and principals now circulating around
(2) Congressional Research Service, ‘Proposal to Allow Treasury to Buy Mortgage-Related Assets to Address Financial Instability, September 22, 2008.
(3) Wall St. Journal, October 11, 2008, p. B1
(4) Congressional Research Service, ‘Fannie Mae and Freddie Mac in Conservatorship’, September 15, 2008
(5) Wall St. Journal, October 18, 2008, p. A3.
(6) Bloomberg, September 25, 2008
Washington will require yet another $500 billion. The idea of hundreds of billions more for ‘incentives’ to banks and other mortgage lenders to compensate them for resetting mortgage rates and principle to keep homeowners in their mortgage is no different than TARP and the other bailouts in terms of ultimate objective. All are in essence nothing more than an income transfer from taxpayers to financial institutions to offset their losses. A ‘cleaning up’ of bad balance sheets of banks and other financial institutions by transferring the losses to the public balance sheet of the government and making the taxpayer cover the losses.

The $2 trillion total may yet rise even further, however. Like pigs coming to a trough at dinner time, various non-financial corporations, insurance companies, and auto companies in particular, have also recently begun to demand bailout funding—or at minimum to be given access to the TARP. The credit card giant, American Express, and one of the world’s largest commercial credit providers, General Electric Credit, have already begun receiving payments. They and others are rushing to adopt phone ‘bank holding company’ status in order to drawn on bailout funds. All sectors of Capital, financial and non-financial, appear now have come to expect the State to provide bailouts. Some call it ‘reverse socialism’, with some degree of truth. One might suggest their new motto as: ‘From each according to his balance sheet; to each according to his portfolio’.

The FED Adds Another $2 Trillion

The coming $2 trillion in bailout funding from the Treasury is still not the entire picture, however. Added to that amount must be $2 trillion more in below market subsidized loans, often without collateral, being showered on banks, financial institutions, and now even non-financial corporations, by chairman, Ben Bernanke, of the U.S. Federal Reserve Bank (FED).

Since last December 2007 the FED has, in a series of six ‘special auctions’, poured money into banks and non-bank financial institutions that were essentially insolvent, in order to prevent them from formally defaulting and going bankrupt. Admittedly, the loans are then rolled over or repaid, and subsequently loaned out to other institutions. But they collectively still represent another massive liquidity injection in addition to that provided by the U.S. Treasury. Since December 2007 the amount of loans made available to financial institutions has been dramatically increased.

Beginning in January 2008 the FED had on hand somewhere between $800 and $900 billion in potentially loanable assets. Last March 2008, when the FED directly bailed out the investment bank, Bear Stearns, to the tune of $29 billion, it also initiated an even more generous second ‘auction’ of funds for the banks. More than $400 billion was then made available. That left the FED with about $300 billion left in loanable assets, out of total assets of around $800 billion it had when the crisis started. With the FED’s bailout of Bear Stearns it essentially had ‘shot off’ its ammunition. Any future direct bailouts would thereafter be the responsibility of the Treasury.

Following Bear Stearns, the FED has had to borrow from the U.S. Treasury to continue loaning ever greater amounts. FED borrowing rose exponentially in September 2008 as result of the collapse in September of one of the world’s largest Investment Banks, Lehman Brothers. On October 22, 2008 the FED announced it was setting aside another $540 billion for the $3.5 trillion Money Market Fund industry, as the latter found itself driven to the brink by more than $500 billion in depositor withdrawals in a matter of days in the wake of the Lehman collapse. (7)

When Lehman went bust in September 2008, investors determined the Lehman bankruptcy would result in significant losses for Money Market Funds and started to withdraw deposits from the Funds. A major Money Market Fund, Primary Reserve, in particular began to experience a massive exodus of withdrawals by depositors and nearly went bankrupt. In response, within days the FED announced it would provide the $540 billion, as well as additional financial support amounting to several hundred billions more to the Commercial Paper market—as that latter market in turn began to freeze up as Money Market Funds stopped loaning to the Commercial Paper market—and additional hundreds of billions to foreign banks to provide dollar liquidity. Subsequently, the FED announced it would provide a ‘swap’ of another $122 billion with Korea, Singapore, Brazil and Mexico—a total that didn’t have to be paid back until next spring 2009.

As market after credit market freezes up in succession, the FED has been called upon to recycle ever greater amounts of loans and liquidity to banks and financial institutions. The escalating amount as of November 2008 is now well in excess of $1 trillion disbursed with commitments for at least another $1.3 trillion. (8)

Before becoming Federal Reserve Chairman a few years ago, Ben Bernanke, then a governor, declared that should depression-like conditions occur, all that would be needed was to “drop money out of a helicopter? to bring it under control. He thus earned the nickname “helicopter Ben?. That moniker, however, is clearly inappropriate. Ben has obviously traded in his helicopter for a B-52 bomber.

Treasury and FED combined efforts of the last fifteen months thus amount to more than $4 trillion in liquidity being thrown at banks and financial intermediaries—with no apparent resolution or containment of the financial crisis yet in sight. Could it be the strategy is wrong? Of course, from a banker’s view it’s exactly what should be done. But then, that’s what bankers do—i.e. take other people’s money and put it in their bank. Which only goes to show perhaps that bankers (i.e. Treasury Secretary Paulson and FED chairman Bernanke) should not be put in charge of resolving a banking crisis!

Whether Treasury direct bailouts, FDIC compensation for depositors of failed banks, or FED loaning money to all lining up at the money trough, the Paulson-Bernanke ‘liquidity strategy’ of the past fifteen months, which is designed first and foremost not to end the crisis but to bail out the banks in the midst of the crisis is not just a liquidity-bailout

(7) Wall St. Journal, October 22, 2008, p. A2.
(8) Bloomberg, November 17, 2008.

strategy. It is at the same time a massive income transfer—from consumer, homeowner, and worker household ‘balance sheets’ to the balance sheets of Finance Capital in its various institutional forms. How much more of taxpayer money will be required to transfer to Finance Capital, before it is admitted that throwing liquidity at the financial sector is not resolving the crisis, remains to be seen.

Political Significance of $4 Trillion Income Shift

Today’s multi-trillion dollar bailout of banks, financial intermediaries and even now nonfinancial corporations has raised a chorus of complaints, even from conservatives, that it all amounts to ‘socialism for the banks’. Editorialists in the Wall St. Journal unabashedly agree, declaring this kind of socialism for the rich is justified, however. So much for free market ideology, that has now not only imploded but has virtually disappeared into a bottomless pit of collapsed capital asset values. A new justificatory variety of capitalist ideology will now no doubt have to be formulated. Their new kind of ‘corporate socialism’ perhaps requires a new slogan. One might suggest: “From each according to his balance sheet; to each according to his portfolio?.

Translated into Marxist terminology, the massive shift in income and social surplus represented by the bailouts means that traditional means of absolute and relative surplus value extraction are no longer sufficient. Despite trillions of dollars having been extracted by such means—i.e. the ‘shop floor’ class struggle—since the late 1970s, such direct forms of surplus transfer are no longer enough. Even State-assisted reduction of the standard of living of the working class—i.e. lowering socially necessary labor values to use Marxist categories—has not proved sufficient. After three decades of shifting income by means of State assisted legislated policies—such as free trade, tax restructuring, union destruction, dismantling pension and health care systems, lowering real minimum wages, reducing overtime pay, diverting the social security surplus to the general US budget—the shifting of Labor’s share of the surplus has now accelerated exponentially with the current financial crisis and bailouts.

What we are now witnessing with the massive $4 trillion and rising bailouts is the State’s deeper and more direct involvement in shifting Labor’s share of social surplus to Capital in magnitudes heretofore unmatched in the history of modern Capitalism. One again to put it in Marxist categories, the rate of exploitation is currently being ratcheted up several-fold.

But the current surplus-income transfer is not simply a shift from laboring classes to capitalist class. What is happening is not just the greatest example in all of history of the Capitalist State functioning as social surplus transfer agent on behalf of a particular class. What is happening is the transfer of the lion’s share of the surplus to a particular sector of that class—i.e. Finance Capital. It is a testimony to the relative shift in power and influence of Finance Capital in the 21st century.

A key question is how has it gotten to this point that Finance Capital is now receiving a massive liquidity injection (read: income transfer from consumer-taxpayer-workers)? How is it the financial system became so fragile and unstable that it cracked? Why has the descent into instability been so rapid, spread so widely, from credit market to market, from geographic market to market, and now from the banking and finance sector to the non-financial economy, propelling the global economy toward a more serious form of economic downturn, an Epic Recession?

If Epic Recession is the direct consequence of the worst credit crunch since the 1930s, and in turn that credit contraction is the direct result of the worst financial crisis and instability event since 1929-1933, then the more fundamental question is what have been the causative forces behind today’s qualitatively more severe financial crisis? The ultimate answer to that latter question is to be found in the fundamental structural-institutional change in the nature of Finance Capital itself over the last three decades But between that ultimate cause on the one hand, and the current financial crisis and consequent Epic Recession on the other, lie a series of critical intermediate causal factors that must be understood as well. The remainder of the article attempts to address those intermediate causal factors.

Some Historical Observations

It is abundantly obvious that the current financial crisis is not an isolated event, but has had its antecedents in the past two decades. To name but a few of the more well known: the Savings and Loan bust in the U.S. in the late 1980s, the Junk Bond blow up shortly thereafter, the Scandinavian bank crisis of the early 1990s, the real estate driven Japan recession of the 1990s, the collapse of the Long Term Capital Management hedge fund in the U.S. at mid decade, the Asian financial meltdown of 1998, the dot.com boom and bust in the U.S. from 1997-2001, the residential subprime mortgage boom-bust, and, most recently, the global commodities bubble of 2007-08 that is now unwinding rapidly with plummeting commodity prices.

What these related events reveal is that the frequency of financial instability events has been increasing over the last several decades. So too appears to be the scope and magnitude of the severity of the financial instability, at least over the longer term. What was an instability event associated with a given market, like savings and loans, or junk bonds, later becomes a more generalized, multi-market affair.

A third important observation is that traditional monetary and fiscal policies have had increasing difficulty containing the crisis. When they have been contained, it has been as a result of larger doses of monetary and fiscal stimulus. Moreover, it appears that, with each containment, the stimulus itself becomes a contributing cause to future, even more severe, instability events. Each time more extraordinary fiscal-monetary measures are required to contain the instability. Each time the events become more unstable.

Yet another observation is that the instability is generalizing geographically as well. Junk bonds in the U.S. or banks in Scandinavia become a problem affecting the entire financial system in Russia or Japan. Then the technology sector cross-nationally. Finally, housing market instability generalizes globally, and then the entire financial system o a world scale. Clearly, something is at work globally, and is growing deeper across credit markets cross-nationally as well.

Some argue the common denominator is unrestricted cross national capital flows, the globalization of capital markets, and the technologies that enable that globalization of capital markets and flows. Financial deregulation worldwide is targeted in turn as the causal factor responsible for those flows. The view is partly correct, but not fundamentally so.

Others point to the loose monetary policies pursued by central banks throughout the world as the cause. Without such policies providing excess money to borrow, more often than not at historic consistent low interest rates, the capital flows would not be as larger or as volatile cross-country and cross-markets.

But increased capital flows, more integrated financial markets, technologies, and long term accommodative central bank policies are only ‘enablers’ for more fundamental forces at work. What matters more is the massive accumulation of Debt that has fed the capital flows, raising the water level of investment in all forms from a normal stream to a flood. Capital flows with a purpose. That purpose is investment, or capital accumulation. Debt is the consequence of borrowing for the purposes of investment. But what kind of investment is the question? Not all investment is the same. Business cycles, recessions and depressions occur because of volatility of investment. But some forms of investment are more volatile than others, and thus cause more frequent, deeper and longer economic instability and downturns.

The Debt-Deflation Nexus

In the U.S. alone, over the past three decades since 1978, total debt—i.e. finance sector, consumer, government and non-finance business debt—has risen from $3.6 trillion in 1978 to more than $47.7 trillion! Between 1978 and 2000, the increase was from the $3.6 trillion to $26.2 trillion, a not inconsiderable sum or gain. But from 2000 until the first quarter of 2008, in barely seven years, the escalation of total debt was from $26.2 to the $47.7. An increase in debt in just seven years equivalent to that which previously took twenty-three years to attain. (9)

Even more interesting is the growing weight and mix of financial sector debt within that total. In 1978 financial sector debt amounted to $412 billion of the total $3.6 trillion, or about 11.3%. By 2000, it was $8.1 trillion and 30.9%. And by early 2008 it was $15.9 trillion or 33.4%. In stark contrast, consumer debt of all kinds (including mortgages) fell from 30.4% of total debt in 1978 to 28.4% by 2008. In other words, the financial sector (banks and financial intermediaries) tripled their share of total debt in the US economy over the period, while consumers experienced a decline in their share. (10)

(9) Federal Reserve Bank, ‘Flow of Funds’ data, ‘Debt Outstanding by Sector’, June 5, 2008.
(10) Same source.

This is not a case of workers and consumers buying too many cars or houses they cannot afford. Workers-consumers debt is the consequence of the increased use of credit cards and housing refinancing in order to maintain standards of living and make up for the essential freeze in pay, adjusted for inflation, since 1982. According to US government Labor Dept. data, the 110 million non-supervisory production and service workers in the U.S.—the heart of the American working class—earn less real take home pay in 2008 than they did in 1982 as a group. Credit cards and housing refinancing has allowed them merely to cover big expenses like health care emergencies, education, and auto purchases that they can no longer afford from their base earnings. The real debt run-up is clearly the consequence of banks and financial institutions. It is first and foremost about the financial sector expanding its share of $48 trillion exponentially faster than the rest of the economy. The massive debt run-up in the US economy is thus clearly financial debt.

The big run-up of nearly $16 trillion in financial sector debt began roughly in the mid-1980s in the U.S. It is perhaps no coincidence that financial instability events soon followed, erupting in the Savings & Loan and Junk Bond booms and busts in the latter half of that decade. Followed the next decade by the Long Term Capital Hedge Fund implosion, Japan’s real estate binge collapse, and the beginning of the dotcom technology boom in the late decade, among other numerous similar events globally.

The key is what forces underlay these financial instability events and what was their link to the financial debt explosion that began in the 1980s and escalated in the 1990s, eventually reaching a fever pitch after 2000? The answer is the orgy of speculative finance and speculative investing. Speculative investment and finance has been the driver of the massive debt run-up. The flip side of the Debt coin is Deflation. The key to understanding the growing financial instability is the Debt-Deflation Nexus, at the heart of both of which lie the growing institutional and structural mix over recent decades of speculative finance and investment within the total mix of investment and the capital accumulation process.

More specifically, the investment in speculative financial assets is at the heart of the debt run-up. Debt is the reflection of the asset price booms associated with the growing weight and mix of speculative finance. Deflation represents the unwinding of those price booms in speculative financial assets. Asset price deflation is what in turn has been driving the accelerating losses and write downs by banks and other non-bank financial institutions. It started with residential mortgage asset deflation—i.e. the subprime mortgages and the collateralized debt obligation bonds, or CDOs, based on those mortgages. It then spread to other speculative financial instruments, to other credit markets—other less risky mortgage sectors, commercial property, asset back commercial paper, junk and high yield corporate bonds, municipal bonds, money market funds, inter-bank lending, bond insurance, Fannie Mae/Freddie Mac agency debt, common and preferred stock of banks marketing the proliferating financial instruments, dragging down stock markets, threatening to spill over to pension funds, and so on almost without limit thus far. The process spread to other financial institutions and to other regions of the world.

Deregulation enabled the process. FED loose money made the borrowing for speculative investment purposes easy and virtually free. The borrowing ran up the financial debt totals noted previously. When the asset price bubbles broke, first in subprimes and then in a chain reaction elsewhere, the ‘great debt unwind’ began. Its unwinding force is asset deflation.

At the core of the Debt-Deflation nexus, however, is the growing weight and mix over the decades of speculative finance and investment. What then is Speculative Finance? What is meant by speculative investment—in contrast to ‘normal’ or non-speculative investment and capital accumulation?

Financial Intermediaries and Speculative Finance

At the heart of Finance Capital is its tendency to seek out and create its own independent forms of value. Finance is generally thought of has the means by which money capital is used to create more value by enabling investment in physical asset (physical capital) accumulation. But the trend has always been for Finance Capital to diverge from this function of enabling physical asset investment (or as Marxists would say ‘complete the circuit of capital’) and to pursue more independent forms of value creation. The reason is these latter forms of financial asset values are more profitable. And Capital will always seek the more profitable opportunities.

Financial asset forms are more profitable because they have virtually no cost of goods or cost of sales, and the demand or market for them is instantaneous and global. Physical asset capital, in contrast, must absorb costs of raw materials, labor, engage in supporting marketing and distribution costs, etc.—all of which reduce its profitability. Financial assets have none of that cost burden and have an immediate global market and global demand available now in the 21st century as a result of technology, unrestricted capital flows, and global financial deregulation. The latter have enabled, even accelerated the trend and process. But the nature of financial assets, the constant pursuit for greater profitability, and the new financial institutional structures that have evolved in recent decades are the true fundamental drivers.

The history of Finance Capital is a history of seeking to expand in the direction of financial asset creation, and to see ways to avoid what limitations and regulations might be imposed on such asset creation by legal, political, or cultural forces. This has always been the case with Finance Capital since at least the mid-19th century. Whenever financial institutions, such as banks, have found themselves restricted by regulations, finance capitalists have done an ‘end run’ around the regulated institutions and formed new kinds of deregulated institutions. These are typically called ‘financial intermediaries’ in literature today. But they are not new. Only their forms have changed. Some early forms of such financial intermediaries created to get around regulatory frameworks were the so-called private ‘trusts’ in the 19th century. They played a major role in provoking banking panics and depressions in the late 19th and early 20th century.

As intermediaries like ‘trusts’ were eventually brought under a regulatory umbrella following a financial bust or depression, new institutional forms outside the umbrella were once again created. The independent broker-dealers, S&Ls, holding companies, and investment banks of the 1920s are another such example of financial institutional innovation. They played a major role in the speculative financial excesses of that decade that led eventually to the asset price busts of the late 1920s and the great crash of 1929. The experience of the Great Depression of the 1930s severely dampened the efforts of Finance Capital to get around the new regulatory framework by creating new kinds of intermediary institutions issuing new kinds of speculative financial assets. The freedom to innovate institutionally and in terms of creating new forms of financial securities was inhibited until the 1970s.

By the1980s, however, the trend began to emerge again, this time even more aggressively. The early forms have now evolved into hedge funds, private equity firms, private banks, dark pool investing, and so on. As the older, regulated banks and financial institutions found themselves unable to compete with the new unregulated financial institutions, they lobbied the State and in stages eventually got the ‘deregulation’ they too demanded in order to compete with their new, unregulated Hedge Fund, Private Equity, et. al. cousins. Banks like Bear Stearns and others created their own in-house Hedge Funds. And in even more aggressive ventures, created new institutions called ‘Structured Investment Vehicles’, or SIVs, that were set up ‘off balance sheet’ of the main bank, into which they stuffed their toxic subprime mortgages and collateralized bonds based on subprimes. Finance Capital thus constantly creates new speculative institutional forms, and corresponding new forms of financial asset products, designed to pursue super-profitable returns. However, over time the inherent tendency toward creating such institutions and more risky, but potentially more profitable, financial instruments or issues results in greater financial instability as well.

The growing weight and mix of such institutions and instruments over time also serves to crowd out non-speculative forms of financial asset investment as well as investment in non-speculative physical assets. This slows down accumulation in physical asset investment and thus the contribution of the investment function to overall productivity and economic growth in general. A scenario of growing speculation leading to more financial instability is therefore combined with slowing real asset investment, growth, and profitability. And as the former become more profitable, the latter become less so. One consequence is that physical asset investment is forced to seek more profitable opportunities offshore.

But as that weight and mix of financial speculation grows, so too grows the tendency and actuality of financial instability. That is because at the heart of speculative investing is the explosion of excess debt created to fund speculative asset accumulation. Excess debt creation leads inevitably to financial asset debt unwind and asset price deflation. In turn the asset deflation drives financial institution losses and write downs that lead to the bank and financial institution default and bankruptcy at the heart of a financial crisis. Finally, when the magnitude debt unwind, deflation, losses and write-downs are particular severe or widespread, the consequence is an especially severe and protracted credit contraction in turn, leading to a corresponding severe recession.

The Nature of Speculative Finance

Understanding the current financial instability and consequent equally severe credit crisis and recession thus requires ultimately a more fundamental understanding of the nature of speculative finance and speculative investing in general, and, in particular, what is new about speculation in the 21st century.

In a most general sense all investment is by its nature speculative if by that term is meant a decision that, made in the present, is about an unknown and uncertain outcome in the future. The unknown and uncertain outcome in this case is will be investment produce a profit. All investors speculate by not all investment is ‘speculative’. But speculative investment and speculative finance (how that investment is funded) as it relates to financial instability and financial crises is something more specific than the foregoing general definition.

Financial destabilizing speculation (let’s call it Speculation with a capital S) is investing based first and foremost with a short term expectation of profit horizon and determined by the volatile movement of price for the invested asset. The Speculative investor does not invest in an asset expecting to hold it long term, say multiple years or even a decade or so. That investor does not invest expecting to receive a long term income stream from the invested asset. He invests with the expectation that he will hold it short term, wait for a significant price change, and then resell or ‘flip’ the investment. The Speculator identifies existing opportunities for rapid price change then enters the market, and by doing so, exacerbates the price movement. Or, he creates a condition that drives the price in order to profit. Typical is what has been happening to world commodity prices over the past eighteen months. Speculators drove, for example, the price of oil on world markets up rapidly, from around $50 a barrel to nearly $150 a barrel. There is no way normal supply or demand could move market price that volatilely. Speculation works with price swings up or down. Thus, Speculators are now driving the price of oil back down to $50. Speculators create and exacerbate price swings in order to reap a quick price-determined profit. They tend toward Speculating thus in financial instruments or issues in particular. Such instruments—such as CDOs with subprimes or other new forms of issues—are driven largely by demand and not costs of production. Thus their price has no constraint. Their price can swing widely. Which is precisely what Speculators want. For example, there is a limit to how much the price of a cellphone can swing. Not so with CDOs, our example. CDOs can be created initially on subprime mortgage bonds but then bundled with other purely financial instruments and repriced higher. Those CDOs can then be bundled similarly with other instruments and again repriced. The process has virtually no upper limit until such time as some Speculators decide to ‘take profits’ and everyone runs for the door. That’s when the market ‘busts’ and prices reverse and decline often just as sharply as they rose.

What has just been described is another characteristic of Speculation, or what is sometimes called ‘Securitization’. Securitization is simply the bundling of financial assets with other assets to create a new security or instrument. Sometimes the originating asset, a subprime mortgage bond for example, may be chopped up into five to fifteen parts, called ‘tranches’. Those fifteen parts are then distributed into fifteen new CDOs. Other assets of good or poor quality may be thrown into the financial salad bowl. From one asset therefore fifteen are created. Each new bundled CDO is then ‘marked up’ in terms of price. The price markup is almost always double digit, never 1 or 2 percent, for example. That new, bundled CDO may then be purchased and thrown into a new financial salad bowl, in whole or part, to create a still newer CDO, and once again ‘marked up’. Financial instruments created thus are highly conducive, in other words, to generating price inflation. But again that’s what the Speculative investor is looking for.

Securitization emerged as a force in financial markets in the 1980s. It was first a factor in the Savings and Loan bubble and bust in the late 1980s. In the last ten years, however, Securitization has become a major determinant of Speculative finance and investment. It helped drive the subprime mortgage market boom and bust in particular. It also played a major role in ‘spreading’ the financial instability globally. Nearly all major financial institutions were employing it, creating and selling new financial instruments and issues on top of instruments. Originating at first primarily in the U.S. and U.K., the practice spread to the EU and other economies. Mortgage backed bonds and CDOs composed of various financial instruments were sold from the U.S. to central banks, banks, wealthy investor funds, etc. throughout the world.

A major conduit was the U.S. quasi-Government agencies, Fannie Mae and Freddie Mac, which were required by law to buy the ‘bad’ subprime mortgage loans created by private lenders. Fannie/Freddie then resold these as their ‘agency debt’ to the tune of $1.7 trillion to central banks and banks throughout the world. When the stock prices of Fannie/Freddie began to collapse last summer 2008, global investors holding their ‘bonds’ demanded the U.S. Treasury rescue the agencies and guarantee that $1.7 trillion debt. If the Treasury had not, those foreign banks would have thereafter refused to purchase U.S. debt. The $U.S. dollar would thereafter collapsed.

Another major characteristic of Speculative finance is what is called ‘leveraging’. Leveraging is when a Speculator borrows funds in order to invest in the speculative asset. When FED interest rates are extraordinarily low, as during the twenty years of what has been called the ‘Greenspan Put’, investors borrow from the FED at very low rates and reinvest in price volatile financial instruments. Thus the FED ‘feeds’ the speculative frenzy. It enables and exacerbates it, but does not create it. This was especially the case during the 2002-2006 subprime mortgage boom in the U.S. and the global housing boom associated with it.

Leveraging is exacerbated as well by Securitization. Together they are largely responsible for the massive run-up in debt by Financial Institutions noted previously. To recall, nearly $8 trillion of new domestic finance sector debt from 1978 to 2000, and more than $8 trillion in just seven years from 2000-2008. Financial sector debt accelerated as a percentage of total debt over the last three decades, starting in the mid-1980s in particular, while other sectors—consumer, non-financial business, and even government—declined as a percentage of total debt. That most recent run-up of $8 trillion in just seven years is clear evidence that Speculative investing accelerated even faster in recent years. It’s relative weight and mix in the total of all investing clearly grew significantly. And as that relative weight and mix grew, so too did financial instability.

Of course, not all the $16 trillion financial debt since 1978, or even the $8 trillion since 2000 is Speculative debt. But much of it, and an increasing portion of all financial debt since 2000, must certainly be. Unfortunately, government data and statistics provide no way to determine the exact mix of Speculative vs. non-speculative finance driven debt. But the role of Securitization which accelerated in particular over the last decade, combined with the super-low interest rates of 2002-06, and the total repeal of the major element of bank regulatory legislation passed during the 1930s, the Glass-Steagal Act, must certainly have accelerated the relative weight and mix of Speculative forms of investment since 2000.

Another factor also clearly played a role since the mid-1990s. It is called ‘Hedging’. Hedging is a financial industry practice that allows ‘betting’ on price swings in both directions, up and down, and simultaneously. By means of arcane mathematical formulas, hedging permits investors to ‘hedge their bets’ that the price of an asset will swing in either direction. Hedging has spawned a new form of totally unregulated financial intermediary institution, called ‘Hedge Funds’, which control nearly $2 trillion in investments. Like Securitization, they too have come into their own in just the last ten years. They too have exacerbated Speculative investing by encouraging bets on securities in both directions. Hedge funds also play a major role in commodities price swings and, in particular, in driving down prices of stock of companies like Fannie Mae, Freddie Mac, Lehman Brothers, and other Investment banks that recently have gone bust in the banking panic of 2008.

Speculative investing is more like ‘betting’ than investing in the traditional sense. Speculators seek out products with volatile price swings. They are largely separated from ownership of firms. They aren’t interested in fundamentals of a company because they aren’t interested in long term investing. Nor does it matter that the originating financial instrument is ‘bad’ in quality or even toxic (e.g. subprime mortgage bonds). The intent is to ‘flip it’ quickly in any event. Because as a group they gravitate quickly toward products with wide price swings, seeking to make profits on the upswing (bull market speculation) as well as on the downswing (bear market speculation), they heavily invest in currencies and exchange rate swings, options and futures, commodities, even interest rate swings, credit insurance for bonds of various kinds, mortgage bonds, and the like. These have all come to be known as ‘derivatives’.

The explosion of ‘derivatives’ is also a strong indicator of the accelerating weight and mix of Speculative investment since the 1980s, and in particular since 2000. Derivative trades outstanding amount to more than $600 trillion dollars worldwide. A segment of that market, Credit Derivatives, sometimes called Credit Default Swaps, or CDSs, is of special importance for the current financial instability. CDSs are ‘bets’ that a particular bank or company will not default and go bankrupt. If it does, the CDS issuer agrees to pay for the losses on the company’s defaulted bonds. There are about $62 trillion in CDS contracts outstanding. As banks and other non-financial companies go ‘bankrupt’ in the next eighteen months, issuers of CDS, which are primarily other banks and financial intermediaries like Hedge Funds, will themselves be unable to ‘cover their bets’ and will default in turn. That will certainly intensify the financial crisis, and provoke a second, more serious stage of financial instability in late 2009 or 2010.

This brief overview illustrates the changes in Speculative Finance and investing since the 1980s and in particular in the last decade or so. It at least begins to explain how and why the massive debt run-up in Financial Sector debt in the U.S., the $8 trillion and $16 trillion, has occurred. Speculative finance, based as it is fundamentally on price swings, cannot be permanently sustained. Prices cannot rise in perpetuity for any asset. Thus, when some investor or group decides to cash in, and others follow (a ‘herd instinct’ is another characteristic of Speculative investing), then prices ‘swing down’ as fast or faster than they swung up. Speculators play the swing up or down, thus exacerbating price volatility in both directions (e.g. the commodities markets today, or the rapid collapse of recent banks’ stock prices, or the wild swings in U.S. and global stock markets in October 2008). When prices swing to the downside, what occurs is called ‘Asset Price Deflation’.

Asset price deflation sets in motion a rapid collapse of asset values held by banks and other financial intermediaries. They must then ‘write off’ or write down the values of assets on their books or default and go bankrupt themselves. As they do so they become technically ‘insolvent’. In order to offset the insolvency condition they must raise capital in other forms on their books. If they cannot (which often proves futile as speculators drive down their stock prices in anticipation of their default), then they must obtain capital elsewhere. Enter the FED and Treasury as primary sources for replenishing lost capital. The FED does so temporarily, by providing loans. The Treasury does so more permanently, by buying up the bad assets or buying the stock of the insolvent institution. That is the meaning of TARP, the bailouts of Bear Stearns, Fannie/Freddie, AIG, and others. But in all these FED-Treasury moves the strategy is basically to pour money—i.e. ‘liquidity’—into the bank to shore up the collapsing balance sheet. The strategy is not to stop the causes of the original insolvency—i.e. the collapsing value of asset prices on the books of the institutions. That is why pouring liquidity in ever larger sums into the banks for the past fifteen months, as the FED-Treasury have been doing, is not resolving the financial crisis in any fundamental way. And that is why the crisis and instability will continue.

From Speculative Finance to Epic Recession

As asset values continue to fall in late 2008, both in the housing market and now spreading elsewhere, it changes the psychology of banks and financial institutions in general. Even if a given institution’s balance sheet is not in trouble, i.e. not insolvent, it too refuses to loan funds to non-financial institutions. Of course, those who are essentially insolvent (and a general cover-up by banks and government has been on-going the past year to obscure the extent of the general insolvency), refuse to lend at all. They especially ‘hoard cash’, or else offer loans under highly onerous conditions for borrowers that the latter choose not to borrow. Instead, the non-financial companies choose to engage in massive cost cutting. This means in particular mass layoffs in industry after industry, which are now beginning to occur. Thus, asset deflation leads to major credit contraction which translates into a general unavailability of credit for the nonfinancial sector as well as the financial.

Asset price deflation spreads from credit market to credit market. In a relatively brief time, the credit contraction spreads as well. The larger the losses and write downs, the deeper and more severe the credit crunch. Also, the longer the insolvency is not resolved, the longer the period of credit contraction and the more serious its impact on non-financial companies.

The asset price deflation then eventually ‘spills out’ and provokes deflation in other markets for products and labor as well. Companies unable to get loans are forced to cut costs drastically, which mean mass layoffs and/or wage stagnation or even wage reduction. Mass layoffs reduce demand for products in general as a recession begins to occur as both real business investment declines and workers-consumers reduce their spending due to loss of jobs and wage stagnation-reduction. Product prices then begin to fall as well. Deflation has now spread beyond just asset prices to product and labor markets as well. Companies in trouble because of declining demand and sales themselves begin to default and go bankrupt. So do consumers-workers who now cannot pay for auto loans, student loans, or other durable, big ticket purchases. Corporate and Consumer defaults rise. This in turn causes a feedback of further losses for banks and financial institutions. A downward general deflationary spiral has begun. Financial instability is now being fed in a cycle of deflation and defaults, financial sector feeding the non-financial and vice-versa. If allowed to continue unabated, the end result is a classic debt-deflation depression as occurred in the 1930s.

Characteristics of an Epic Recession include the early stages of such a debt-deflation spiral. The U.S. has clearly entered such an early stage. Asset deflation, in particular in the housing market, has not been contained or even checked. Housing asset prices will fall at least another 20% in the U.S. Deepening financial instability has provoked a definite downtrend in equity asset prices (stock market) despite the volatile wide swings in stock prices (driven up and down by Speculation). Commodity prices are in freefall. Signs are appearing that, as mass layoffs are now being announced, wage cuts for workers still with jobs are appearing. This has thus far largely taken the form of converting full time workers to part time in the hundreds of thousands every month—i.e. in effect a wage cut. More direct wage cutting is beginning to appear as well. Not least, product price deflation is beginning to appear, most notably in the auto and housing related industries. The worst Xmas retail sales season in decades is about to begin. It will result in large cuts in product prices before and after. In short, the deflationary spiral is now underway. It will inevitably lead to further losses and write downs at financial institutions.

As the losses continue and grow in the financial sector, and the consequent credit crunch for non-financial and consumers continues as well, 2009 will witness the beginning of major corporate defaults and consumer credit defaults as well. The Standard and Poor’s rating agency, for example, predicts a tenfold increase in corporate defaults over the next 18 months. Major credit card companies like American Express and consumer credit arms of GM and General Electric are all setting aside large contingencies for consumer defaults. These non-financial sector defaults will result in another major wave of banking and finance losses, write-downs, defaults and bankruptcies in the wake of the corporate-consumer defaults. The crisis will have shifted to a more serious phase or stage.

Epic Recession is a reflection of this shift. It is already well underway. Epic Recession is not simply a deeper or longer recession than that typically associated with a postwar recession. Epic recession is characterized by a debt-deflationary dynamic, and the spread of deflation out of financial assets to non-financial sectors—i.e. product and labor markets. Epic recession is by nature also a synchronized, global downturn. That too is also now clearly occurring, as the ‘decoupling’ of emerging third world economies, a theme in the recent past by economists and wishful thinkers, is clearly proving to have been nonsense. Epic Recession is also characterized by increasing currency instability, which is also growing.

But if the debt-deflationary dynamic is the key precipitating development, behind it lies the originating cause of the growing weight and mix of Speculative finance and investment since the 1980s in general and, in particular, over the last decade. The extraordinary debt build up by the financial sector is the expression of that Speculative finance excess. The unwinding of that massive Speculative-driven debt is the causal force driving in turn the deflation in financial assets, which, if uncontained, eventually drives deflation in product and labor prices, deepening eventually in turn the financial crisis.

Sometime similar to the above scenario is precisely what happened in 1930-31. The original financial crisis did not initially provoke the Depression. The general concensus at the time was the U.S. was in the midst of a particularly severe recession but not yet a depression. But the initial collapse of asset values in 1929-30 lead to a chain reaction of deflation, layoffs, and defaults in the non-financial economy that eventually fed back upon the financial instability and exacerbated it. The result was a second and third wave of banking crises in 1932 and 1933, a more synchronized global downturn, extreme currencies instability (and consequent collapse of gold standard and global trade), and what came to be identified as the great depression of the 1930s.

The U.S. today is somewhere on that track, albeit in the early phase. That early phase, with the potential to revert back to a more ‘normal’ recession or to evolve on toward a more bona fide global depression, is that is called a stage of ‘Epic Recession’.

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