Global Trends, Faultlines and Tectonic Shifts: A Historical Perspective on the 2008-2009 Crisis

 Bülent Gökay and Darrell Whitman

At the conclusion of his widely popular 1987 study of the global political economy, titled The Rise and Fall of the Great Powers, England-born and Oxford-trained Yale historian Paul Kennedy observed, “The task facing American statesmen over the next decades . . . is to recognize that broad trends are under way, and that there is a need to ‘manage’ affairs so that the relative erosion of the United States’ position takes place slowly and smoothly” (Kennedy, 1989: 534). In chronicling the decline of the US as a global power, Kennedy compared measures of US economic health, such as its levels of industrialisation and growth of real gross national product (GDP), against those of Europe, Russia, and Japan. What he found was a shift in the global political economy over the last 50 years generated by underlying structural changes in the organisation of its financial and trading systems.

Kennedy’s arguments about a structural decline in US power are shared by other critical historical thinkers who similarly see global political economy through a historical lens. Andre Gunder Frank (ReOrient, 1998), Emmanuel Todd (After the Empire: The Breakdown of the American Order, 2002), Giovanni Arrighi (Adam Smith in Beijing: Lineages of the Twenty-First Century, 2007), Niall Ferguson (The Ascent of Money, 2008), Peter Gowan (“Crisis in the Heartland”, 2009), and Fareed Zakaria (The Post-American World, 2008) all use history to argue that US power is declining in parallel to a rise of regional powers, and particularly China. In their view, this decline is not the consequence of “bad behaviour”, even if bad behaviour has occurred, but is the function of structural changes that have occurred as the global economy attempts to adapt to changing historical circumstances. Our analysis of the roots of the present crisis similarly finds that historical change has affected the structures of the present system in ways that its original design did not anticipate, and argues along with Frank, Arrighi, Gowan, and Zakaria that these changes are long-term trends that cannot be mitigated by regulatory reform but must be accommodated through structural adaptations that recognise emerging political, economic, and environmental realities that cannot be contained by Euro-American global capitalism.

Immediate Cause of the Present Crisis

As of this writing, economic opinion has converged around a consensus that the immediate cause of the present global crisis was sub-prime mortgage lending in the US that spread through an interconnected global financial system.(1) We argue that this sub-prime lending, which began in the U.S. in the early 2000s and spread to parts of Europe thereafter, was generated not for the purposes of either providing housing to those previously excluded from home ownership, as many mainstream economists and politicians have argued, but in response to a massive accumulation of capital in the international financial system that required profit-oriented investment.(2)  The perception of prosperity was largely fabricated on the basis of a housing boom and highly leveraged real estate speculation.  While sub-prime lending was accompanied by the development of new speculative financial instruments, in operation it functioned as part of a money merry-go-round that was created within global capitalist financial structures to enable the expansion of global capitalism. This expansion involved privatising important elements within the system, such as currency management and banking, in ways that removed them from public scrutiny and regulation.

By closely examining how sub-prime mortgage lending served the global money merry-go-round, we hope to offer insights into the more pernicious features of the global capitalist political economy that have plagued it with recurring economic crises since its creation at Bretton Woods in 1944. Of particular importance has been the role of the US in acting as the economic policeman for this system, and the way that it has encouraged, rather than discouraged, a proliferation of complex investment tools that masked the true nature of underlying capitalist economic activity. In so doing, the US oversaw a structural transformation of international banking that interconnected global financial institutions and exposed them to speculative losses they little understood. This framed the current crisis as the first truly global economic contraction in more than 70 years, making it a direct challenge to continuing US economic and political leadership. As capitalist governments scramble to regain control, they are confronted not only with the failure of US leadership, but also the inadequacies of the Bretton Woods system to accommodate the global shifts and systemic faultlines that now infect global economic and political relationships.

Sub-prime Mortgages and the Money Merry-go-round

As the term suggests, “sub-prime” mortgage lending was highly speculative because it targeted potential buyers that otherwise could not qualify for standard home loans. The “sub-prime” element in these loans was the below-market rate of interest charged during the initial loan period, which would last 3-5 years, depending on the loan terms. However, once the initial period passed, the rate was destined to rise, raising the underlying mortgage payment. Additionally, many, if not most, of these loans were made with little or no down payment, instead of the 5% or 10% usually required in standard home mortgages, down payments were effectively folded back into the original loan, which, when closing costs and fees were added, made the amount of the loan exceed the stated price of the house. The underlying premise of sub-prime lending was that borrowers would be able to accommodate higher payments in the future, either because their incomes would increase, or because the value of the house itself would continue to rise creating equity for the borrower where none had earlier existed.

The amount of global capital devoted to US sub-prime lending was staggering, amounting at one point to some $12 trillion in the US alone.(3) Yet, even as sub-prime mortgages carried risks related to their character, these risks were not equally distributed among the borrowers, lenders, and ultimate holders of these mortgages. For example, loan originators, who earned large fees for making but not managing these loans, were exposed only to the risk that the market would collapse, leaving them with few customers. On the other hand, borrowers bore the risk that their income would not keep up with the increase in their mortgage costs, or that the value of their property would decline, leaving them “upside down” on their mortgage, a condition where the value of their mortgage exceeded the value of their house. However, the greatest risk was born by the ultimate holder of the mortgage, because they had no direct knowledge of the actual value of the property, the circumstances of the borrower, or the prospective long-term value of the home. While the low risk, high-profit motive of the loan originators is apparent, and the deferred risk motives of the borrower can be understood, it is still difficult to understand why sub-prime mortgages became such a major part of the US home loan industry, or why the ultimate holders of these loans would agree to buy them.

On closer inspection, sub-prime mortgages were driven by lending practices that created an illusion of opportunities for risk-free profit. With huge amounts of capital pouring into the US through the purchase of US treasury notes and corporate stocks and bonds, US interest rates, including mortgage interest rates, fell steadily through much of the 2000s. Yet, at the same time opportunities for traditional investments in the US were shrinking as the US increasingly bought more and more of its goods and services from low-wage countries. This created the “problem” of the excess capital requiring new outlets for profitable investment, which was solved by channelling it into real estate at all levels. Sub-prime loans thus became a popular investment because they offered a quick profit to the lending industry, and the appearance of long-term profits to the ultimate managers of the loans, based on the seemingly unstoppable rise in real estate values.

The loan originators in the US were led by Country Wide, which, as its name suggests, was a major national mortgage lender, and Freddie Mac and Fannie Mae, two quasi-public lending agencies that originated home loans on behalf of the US government. These and other smaller lenders were encouraged to enter the sub-prime market by public officials, who wanted to both appear to generously extend home ownership to the working class and poor and a profitable outlet for money invested in Treasury notes. Seeing the potential for speculative profits, major banks joined the sub-prime parade by buying up and repackaging sub-prime loans into investment bundles that mixed them with traditional loans and resold them at a considerable profit to other investors in the US and throughout the world. Along the way, various security ratings services got into the act by offering assurances, for a price, that these bundled loans were AAA rated as low-risk investments. As the money merry-go-round spun faster and faster, generating quick and seemingly risk-free profits to lenders, banks, and the US Treasury, no one seriously questioned how this was possible.

The illusion of risk-free profit was promoted by the way that the global financial system had become enmeshed in a web of privatised, quick-profit schemes generated by capitalist speculators. In the decade between the mid-1990s, when the global economic system was transformed and largely privatised, and the first tremors of crisis in 2007, an alphabet soup of new speculative financial tools emerged. At the time, and under the influence of a powerful capitalist narrative of profit generated by neo-liberalism, few asked and even fewer understood how these tools worked, but several have now been demystified and exposed as reckless, if not criminal, covers for looting the system. One of the most popular tools was a financial “derivative”, such as the bundling and reselling of sub-prime loans, which simply referred to several ways of disguising the nature of an investment and its risks from potential investors. Citibank, Morgan Stanley, and Lehman Brothers were major sources of these derivatives, which earned them huge profits during the 2000s. A second and particularly onerous tool was the “credit default swap” CDS, which acted as form of insurance to cover the risk that an investment might go sour. American International Group (AIG), which was a relatively small insurance company in the 1990s, gorged itself on CDSs during the 2000s to become among the largest insurers in the global market. But unlike a prudent insurer, AIG paid out the fees it earned for issuing a CDS to its own corporate officers and shareholders, keeping only a minimum of capital in reserve. As investigators subsequently discovered, driven by insane profits none of these capitalist corporations did much to determine the actual risks involved in derivative or CDS investments, leaving the entire structure of global finance exposed.

For their part, sub-prime borrowers, who were generally members of the working class that had long been excluded from home ownership, either accepted sub-prime mortgages because they were their own choice, or were pushed into it by the lenders who saw them only as profit opportunities. Before the credit crunch, mortgage providers were giving out home loans worth 125% of the value of the property, stretching homeowners way beyond their means. Few of them, however, had any real knowledge of how sub-prime mortgage lending worked, or about the longer-term risks that they accepted along with their sub-prime loans. Rather, lenders commonly enticed their applications by assuring them that the risks were small and that they would be able to manage the loan in the future because housing prices would continue to rise, allowing them to either sell for a profit or take out a second mortgage to cover the difference. Once the loan approved, these lenders disappeared, leaving the borrowers to grapple with the consequences as the lenders escaped with their fees as the loans themselves were sold and then resold to other investors.

How Banks Failed

The money merry-go-round of sub-prime lending could not have developed without the changes in the global financial system that allowed for the accumulation of the vast amounts of capital that it required. These changes, generally understood as neo-liberal reforms, included both the promotion of new privatised financial investment tools, and the deregulation of banking, which spread through the US-controlled Bretton Woods economic system through its interlinking of global financial institutions. This allowed high-risk sub-prime mortgages to insinuate themselves into the fabric of ongoing financial activities without a test of their underlying value. As a consequence, second-, third-, fourth-, and fifth-tier investors, many of them international banks, were never required to account for the value of the sub-prime mortgages that they held, until the system began to unravel in 2007.

Looking at the current crisis as interlinked problems with the valuation of bank assets, it is easier to see how the collapse of sub-prime lending acted to constrict the free flow of money necessary to keep the global capitalist system working. The first chapter in this story came when world stock markets peaked and began a sympathetic decline in October 2007, signalling that a global rather than national economic crisis was unfolding. The role of banking in the crisis then became apparent when news of a sharp drop in the profits of Citigroup led to a sharp fall on the New York Stock Exchange in January 2008, which then spread to global markets on January 21 as other US and European banks disclosed they also had suffered massive losses in 2007. Thereafter, several key financial dominos in the global system began to fall, beginning with the venerable Wall Street investment bank Bear Sterns, which was rescued by the US Federal Reserve in a controversial move in March 2008 that merged it with the Bank of America as it was nearing bankruptcy.(4) The crisis was held in relative suspension for the next several months as capitalist speculators debated how US government actions might rescue the global economy through various stimulus schemes that would inject hundreds of billions of dollars into the US national economy, and through various schemes that would rescue the US banking system. The debate ended, however, in September 2008 when Lehman Brothers, a 158-year-old international investment bank and one of the largest financial institutions in the US, was forced into bankruptcy.

The failure of Lehman Brothers was immediately caused by the reluctance of the US government to step in with yet another bank rescue, which was attributed to a split within capitalist policymakers between those that favoured purely “free-market” economics that would allow any institution to fail in a competitive marketplace, and liberal capitalists who argued that Lehman Brothers was “too large to fail” because its failure would trigger a “credit crunch”, or inability of banks to provide loans except to their very best customers, as banks withdrew from lending in the face of uncertainty about loan risks. The decision to let Lehman Brothers fail first demonstrated that the risks of a credit crunch were very real, but also revealed how governments played a key role in managing capital markets. The relationship between banks and the government economic management had been first raised by commentators with the rescue of Bear Sterns, who observed that its rescue was required “to prevent key financial players from going under”,(5) but without noting just who qualified as a “key” financial player. Because the capitalist markets reacted favourably at the time, the rescue of Bear Sterns became a further argument in favour of rescuing Merrill Lynch, Goldman Sachs, and Morgan Stanley, three other giant investment groups, after Lehman Brothers failed. Thus, gripped by fear of a total financial meltdown the US government began to pour hundreds of millions of dollars directly into major US banks, predicated on the ability of this rescue, deemed the “Toxic Asset Relief Program” (TARP), to relieve the speculative pressures that were enveloping the US banking system.  However, this too failed to stem the crisis and other and even larger and more visible interventions by the US and other capitalist governments followed during the Fall of 2008 and Winter of 2009 – which together were the largest synchronised government interventions in markets since the 1930s.

Even as the US and European governments coordinated action in November 2008, the crisis intensified in the US and Europe, and spread to other national banks and economies, with a particularly vicious impact on those, such as Iceland, that had been most active in the global financial system. This radically changed forecasts about the global economy, with the International Monetary Fund (IMF) first revising its projections for real global 2008-2009 GDP growth downward in November 2008 to 3.7% in 2008 and 2.2% in 2009, against its earlier projections of 3.9% in 2008 and 3.0% in 2009.(6) It also saw that the distribution of growth would be uneven, with advanced economies actually contracting by 0.25% in 2009, which would be its first annual contraction for those countries since World War II, and 2009 GDP growth in emerging economies receding to 5.1%, instead of the 6.1% earlier forecast.  Most notably, the IMF predicted the US economy would shrink in 2009 by 0.7% and the UK would suffer the greatest decline among western European countries by contracting 1.3%. Taken as a whole, these projections meant that emerging economies would provide all real global GDP growth in 2009 and bear the burden of rescuing global economic performance after 2010.(7)

The revisions made by the IMF in November quickly proved inadequate, and it was forced to update them again on January 28, 2009, projecting even slower growth, with the world economy assuming its slowest pace since World War II. In this case, overall growth was expected to be only 0.5% in 2009, with economic activity contracting in the US by 1.5%, in the Eurozone by 2%, and in Japan by an even greater 2.5%. This revision also projected that growth in the developing economies of China and India would decrease to 5.75% and 5% respectively, thus limiting their ability to act as major engines for the world economy.(8) This led IMF chief economist Oliver Blanchard to admit, “We now expect the global economy to come to a virtual halt.” Then, in March 2009 the IMF further warned that the world economy would likely contract this year in a “Great Recession” that would be “the worst performance in most of our lifetimes”.(9)

The IMF was not alone in its gloomy assessment as the World Bank reported in December 2008 in Global Economic Prospects 2009 that world trade would contract in 2009 for the first time since 1982, with the decline driven primarily by a sharp drop in demand as the global financial crisis imposed a rare simultaneous recession in high-income countries and a slowdown across the emerging economies.(10)  At the national level, the US Federal Open Market Committee (FOMC) similarly revised its earlier economic projections on February 18, 2009, predicting that 2009 economic growth would slow further, while inflation and unemployment would increase.(11) These revisions were understandably hostage to the crisis itself and further revisions were likely to follow that would drive down expectations even further.(12)

As dark as these dark forecasts were, they represented a conservative view by mainstream capitalist economists who tried to put the best face on events. Thus, these reports minimised or ignored how this and earlier crises imposed long-term structural damage on the global economy, choosing rather to blandly predict an economic “recovery” in 2010, based on past experience rather than on the crisis’s peculiar global and financial characteristics. For example, in its 2009 forecast the IMF forecast a 2010 recovery with the caveat that the economic contraction would be more prolonged in certain countries, including the US and the UK (13) Yet, with past experience as a guide these official forecasts look increasingly weak as new measurements of economic activity reveal a much deeper annual decline in the US fourth quarter GDP, far beyond the 3.8% earlier estimated, with private US investment falling in that quarter at a 21% annual rate and the Japanese economy contracting at a 12% annual rate.(14) Thus, prudence argues that official estimates be seen more as self-interested “guesstimates” than as fact, with a parade of downward revisions into the future.

All of these separate facets of the current crisis came together in the banking system because each of them lowered the underlying value of bank assets, which limited the ability of banks to provide credit. With an integrated global economy functioning through an interconnected financial system, whatever happens within the system, whether at the centre or periphery, becomes a factor in determining the value of assets held by banks. This creates a circular process, where a crisis in any part of the global economic system translates into financial factors that feed into global finance creating a crisis in proportion to the weight of the initial crisis that initiated the cycle. Thus, because the US dominates the global economy and leads its financial sector, its sub-prime mortgage lending and crisis of confidence in bank assets has become the defining factor in generating a global financial and now economic crisis. As political economists understand, this is what makes economics political and not just a collection of calculations.

It also is the case that the effects of the global crisis will not be evenly shared among developed or developing economies, and what happens within the countries of the EU will differ, and in some cases significantly, from what happens in the US or Japan. This is borne out by the way the new central and eastern European members of the EU and the poorer economies in the global system are experiencing the crisis with far more limited resources, tools and prospects,(15)  and is chronicled in the plight of developing economies that have already been forced to seek emergency funding from the IMF and World Bank, or face the dark near-term prospect of not meeting their basic needs.(16)

 

Bülent Gökay is a Professor of International Relations in Keele University and the Chair of Editorial Committee of Journal of Balkan and Near Eastern Studies. Dr. Darrell Whitman is a licensed attorney, community activist, and educator with a professional background for over 30 years in public interest law, environmental program management, and university-level research, and teaching, and is currently undertaking research in Environmental Politics in California.


Notes

(1) Sub-prime mortgages carry a higher risk to the lender (and therefore tend to be at higher interest rates) because they are offered to people who have had financial problems or who have low or unpredictable incomes.

(2) In “Global Imbalances and the Financial Crisis” (Council on Foreign Relations, Special Report No. 44, March 2009), Steven Dunaway characterized this development as “imbalances between savings and investment in major countries”, which he attributes to flaws in the international financial system that allowed governments, as well as private investors, to evade the consequences of their economic choices.

(3) John Gittelsohn, “Ex-subprime exec works flip side of the market”The Orange County Register, March 16, 2009.

(4) The U.S. Federal Reserve is a quasi-public central banking system managed by a board whose members are appointed by the U.S. President and confirmed by the U.S. Congress, but who act independently of both political institutions in setting U.S. monetary policy. This independence in the past has led to conflicts between the political interests of the U.S. government and the economic interests of private U.S. banks when the Fed acts to protect financial capitalist at the expense of the interests of industrial capitalist.

(5) Neil Irwin and David Cho, “Fed Takes Broad Action to Avert Financial Crisis”Washington Post, March 17, 2008.

(6) Gross domestic product is a measure of economic activity in a country that aggregates all the services and goods produced in a year. There are three main ways of calculating GDP by measuring national output, income and expenditure.

(7) “World Economic Outlook Update: Rapidly Weakening Prospects Call for New Policy Stimulus”, IMF, November 6, 2008.

(8) “World Economic Outlook“, IMF, January 28, 2009.

(9) “Global economy to contract in ‘great recession,’ IMF warns”Reuters, 10 March 2009.

(10) “Prospects for the Global Economy”Global Economic Prospect 2009, World Bank, 9 December 2008.

(11) “US FED: Fed Worsens Projections For 2009 GDP, Inflation, Unemployment”Forbes.com, 18 February 2009.

(12) It should be understood that official projections rely on economic data generated by governments, and that in the U.S. the process of producing this data has become highly politicized with the process of data collection and reporting increasingly tilted toward underreporting politically sensitive data.

(13) Shobhana Chandra and Alex Tanzi, “U.S. Economy May Shrink 1.5% in 2009 as Recession Stymies Fed”,Bloomberg.com, 13 January 2009.

(14) Connor Dougherty and Kelly Evans, “Economy in Worst Fall Since ’82“, Wall Street Journal.com, 28 February 2009.

(15) See, e.g., “How to Prevent a Financial Crisis in Hungary and Avoid a Domino Effect”, January 2009.

(16) “Global short-term growth revised downwards as economic prospects deteriorate“, Euromonitor International, 27 Nov 2008.

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