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International Socialism, Winter 2008

Costas Lapavitsas

The credit crunch

From International Socialism 2 : 117, Winter 2008.
Copyright © International Socialism.
Copied with thanks from the International Socialism Website.
Marked up by Einde O’Callaghan for ETOL.

Can you explain how the current crisis, centred on subprime mortgages, developed in the US economy?

As with all credit and financial crises, this has roots that go some way back. After the 9/11 attack in New York instability and fear pervaded financial markets. In order to steer the US and world economy out of a tight corner there was a reduction in interest rates and loosening of credit, encouraging people to borrow to sustain demand.

Banks took advantage of this and started to push mortgages. The subprime problem developed gradually. This is typical of credit crises. First, banks lend on fairly good terms but then competition sets in. At first, things look OK because the banks get away with it. Then they begin to engage in increasingly risky lending, such as lending on subprime mortgages.

Risky lending was made easier by the recent transformation of the way banks assess lending. In the past getting a mortgage, or most other loans, was a fairly relational process. The borrower would go to the banker and seek a personal relationship, trying to persuade the banker of his or her creditworthiness. Some of the small and medium borrowers in the US and the UK would even go for meals with the bankers, join the same local clubs, and so on. But in the past two decades, peaking in the past seven or eight years, this has fallen by the wayside, and now assessment of credit has become a pseudo-scientific quantitative process. This is called credit scoring. Bank employees tick a few boxes in an assessment form, assign some points per answer and, if the applicant is above a certain threshold, give them the loan.

When mortgage applications are judged on this basis, all that banks need is a number rather than a long-term relationship. As long as lending appears to be going well, they have an incentive to lower the threshold. And they continue lowering it in the face of intensified competition from other banks. This greatly helped to create the subprime crisis.
 

Riccardo Bellofiore refers to the creation of consumer debt as a sort of “privatised Keynesianism”.

There is certainly an element of that. There are even voices calling for more of this, should the unfolding crisis turn into a recession. This kind of Keynesian-inspired response has never gone away. That is also what the Federal Reserve did in the US after 2001. They know how to take such action as a short term response to crisis, but the longer term reaction of the economy to the current crisis has every chance of being very severe.
 

What was the role of the increasing complexity of finances in exacerbating the subprime crisis?

The subprime market is not very large. Nobody knows exactly how big it is, but it is not more than 15 to 25 percent of the total volume of mortgages currently outstanding in the US. That’s bad enough, of course, but what makes it into a potentially major crisis is what has happened to finance more generally over the past 15 to 20 years. Once banks made the mortgage loans – based on “scientific” credit scoring – they proceeded to sell them. In other words, they treated loans as assets that would guarantee payment of a stream of interest to whoever owned them. That is what “securitisation” is about – selling bits of paper that give rights to interest payments accruing on separate loans.

A whole host of new institutions emerged that began specialising in that. They would obtain cheap credit in the environment of low interest rates after 2001, use it to make loans, and then securitise them. Other financial institutions would also use cheap credit to buy the new securities. Still other financial institutions would combine several of these securities to create even more complex, “synthetic” Collateralised Debt Obligations, which give their holders the right to interest accruing on the earlier securities, and so on. In this baroque and opaque world, fuelled by cheap credit, it did not take long before just about all the major financial institutions across the world found themselves holding securities that contained bits of subprime mortgages.

What was originally a small sickness within the US economy grew enormously because of the way capitalist credit works. Since it has spread so widely – assets being created on the back of other assets that ultimately go back to the subprime market – the valuation of bank assets, and ultimately bank solvency, has also become deeply problematic.
 

The rating agencies, which assessed the risks associated with these assets, have also played a role.

That is all part and parcel of securitisation. For the buyer to purchase securitised assets with any kind of confidence, somebody independent of the seller has to appear and say, “Yes, these represent good flows of interest in the future.” That’s the role of the rating agencies. They are approached by the seller of the securities, and there is a lot of pressure on them to approve what the seller is doing. After all, it is not easy if you are Moody’s to tell Citigroup, “What you are trying to securitise is a load of rubbish.” If the rating agencies did that, they would risk losing business. It appears they were giving “triple A” ratings without doing any serious investigation of the underlying loans.

More broadly, though, the crisis is not the result of malfunctioning rating agencies but of the failure of markets. The financial market, which is supposed to assess everything that is put up for sale and then price it appropriately, has obviously failed, and failed dramatically. Yes, the various agents must take their share of the blame, but the system as a whole is really to blame. After all, one of the key functions of banks in the capitalist economy, presumably, is to check borrowers before they advance them money that ultimately belongs to depositors. On what grounds did the banks pass this function on to someone else who obviously did not do the job well? And is there anyone in contemporary financial markets who properly checks the creditworthiness of those who borrow other people’s savings?
 

Marx makes the distinction between two sorts of financial crises. Some are just small problems at the top that create a panic; others indicate much more deep-seated problems. It is very easy to confuse one with the other. So the 1987 stock exchange crash created absolute panic for about a month and then, a year later, it seemed to have gone. How serious is this one?

This is the most difficult question to answer. I am not going to make a prediction because you can end up looking like a fool six months later. I prefer to discuss the broad determinants of crises and draw conclusions in that way. Marx’s point is a very important guideline in understanding and discussing financial crises today. Financial crises are a permanent feature of contemporary capitalism. Every few years there is a financial crisis of one type or another and, as you say, some of them blow away, while others have long-lasting and terrible effects like the one that started in Japan 15 years ago. Even today Japan has not returned to what it used to be.

So the real question is whether what we are witnessing now is a passing storm or a Japanese-type crisis. And the further question is, why does contemporary capitalism keep throwing out these crises?

In answer to the first question, my sense from what has gone on so far is that this may prove a deep and long-lasting crisis. Most of the world’s major financial institutions hold some problematic securities or have advanced problematic loans. Until that bad credit works its way out and is dealt with, all these institutions will be hampered in advancing fresh credit. And if fresh credit is not easily available, the capitalist economy does not work well.

Before they can deal with the bad debt problem, however, they have to know how big it is. And no one knows how big it is, for the reasons that I have already mentioned. But the longer it takes them to deal with it, the longer the malaise will last.

It is interesting too that the reaction of those in power has so far been similar to the reaction of the Japanese authorities back in the early 1990s. At the time the Japanese were blamed for being incompetent. At first they did not realise that banks held so much bad debt, and then tried to keep the lid on it, pretending that it was nothing really. Then they imposed a freeze on the housing market. Only gradually did they admit how extensive the problem was. Well, it has taken over three months for the US authorities to begin to comprehend the extent of the problem. And they are now talking about freezing interest rates in the subprime market.

But I do not see any obvious way of dealing with these problems, even after fully realising how big they are. The big US banks, for instance, at the behest of Ben Bernanke, chairman of the Federal Reserve, have been trying to create a “super-fund” that would acquire bad debts and help clean the portfolios of banks. That is a classic response of banks to such problems – we saw a similar thing in Britain with the secondary banking crisis in the early 1970s. And in similar fashion, the healthier banks in the US are now refusing to contribute money to such a fund, asking, “Why should I take your problems on my balance sheet?” This is truly a brotherhood of wolves.
 

When you spoke at the recent political economy school hosted by this journal you pointed out that there have been recent stockmarket crises and currency crises, but this is a banking crisis. Can you spell out a bit more what that means?

That is why I keep going back to what happened in Japan in the 1990s. For ten years various Western commentators argued, “The Japanese crisis occurred because the Japanese were inept.” But the Japanese crisis was a true banking crisis, and there has not been a true banking crisis in the Western economies for a long time.

A banking crisis is different to a stockmarket crisis. The stockmarket is basically a market in loanable capital through which companies buy other companies. Prices are based on expectations and they have a strongly fictitious element. The actual traded volumes of loanable capital, moreover, are relatively small. A stockmarket slump certainly has the potential to do some damage to companies and banks, but its effects can also be limited.

Banks, especially large commercial banks, are different – they are the foundation of the capitalist financial system because they create most of the fresh credit and they create money. They are not like other financial institutions of similar size such as pension funds. If banks carry bad debt and cannot deal with it, the financial system as a whole cannot work well.

That is what we are witnessing now. The epicentre of the crisis lies in the money market, which has been unable to function properly since last August. The money market is where the banks lend to each other, something that is fundamental to capitalist finance. Money market lending gives flexibility to banks and is a reliable way of pricing what they sell. If the money market does not work well, then banks cannot work well. Since August the money market has gone from a complete freeze to just about chugging along. The reason is obviously that banks do not trust each other, since all of them carry assets that are contaminated by subprime loans. Deep uncertainty in the money market has meant that the financial system has had increasing difficulty in creating fresh credit.
 

How can this crisis in the credit system feed back into the wider system of productive capital?

The crises of recent years have been quite different from the crises of the 19th century that Marx analysed, as well as from the crises of the 1970s that a lot of us experienced at first hand. Traditionally, banks lent to productive enterprises and their profits were a share of the surplus value generated in production and paid to them as interest. Today big businesses at the core of real accumulation rely less and less on the banks for borrowing, and less and less on external finance in general. Investment seems to be financed increasingly through retained profits. As a result, in the past two to three decades financial institutions have had to seek other sources of profit. And that has meant moving increasingly into areas that are not directly connected with the generation of value and surplus value.

In doing so, finance has become relatively autonomous from productive enterprises as well as growing rapidly. The process of real accumulation and value generation has not grown to anything like the same extent.

So what happens is that banks engage avidly in expanding consumer credit and housing credit. They have also become far more involved in facilitating participation in financial markets by corporations and others. Rather than directly lending to big business, banks charge fees to big business for help with floating shares, bonds and other securities on the open market. Consumer credit, mortgage lending and fee incomes are the fastest growing sources of bank profits.

In that context banks have an almost inbuilt incentive to create bubbles, particularly when they lend for consumption and housing. If banks expect to get their profits increasingly out of interest drawn from wages and salaries, rather than surplus value, they have a problem. There is no guarantee that wages and salaries will grow systematically in future. Indeed, in the past 20 years real wages in the US have been stagnant.

Another way of putting this is that the options for banks are inherently limited if they focus on lending to private individuals. They can increase their profits by appropriating a larger part of wage income, but obviously this has its limits, especially if real incomes are not rising. Banks can also manufacture asset price bubbles. If financial asset prices rise, banks can make additional profits by drawing fresh groups of individuals into the market under the pretext of capital gains and secure lending. If banks create a housing bubble, for example, people appear to become richer even though real incomes are not necessarily rising. Fresh groups of borrowers are attracted into the markets, or existing ones become more heavily indebted, and banks make extra profits by transforming an increasing part of aggregate personal income into loanable money capital.

When these bubbles burst, the first to feel the pinch are workers and others who have borrowed excessively. Millions of people in the US have already lost, or are due to lose their homes this year and next. It is shocking that at the moment not a word is said officially about their plight. But as workers and others are hurt by the burst of the bubble, consumption suffers and this has knock-on effects on real accumulation too.

It is clear that this is not the same mechanism as described in classical Marxist analysis where the capitalist firm would borrow, over-expand production, be unable to sell its products and therefore find it impossible to honour its debts to banks and others. Then the firm would be forced to curtail its output, and possibly even go bankrupt. The current crisis has followed a different mechanism. There will be an impact on the real economy, but the paths will be unusual.
 

You seem to be talking about a system in which wages are held down and in order to consume all the goods produced by capitalist enterprises it is necessary for consumers to spend beyond their means, backed up by rising house prices. When this system goes into crisis it can no longer consume everything produced. That then impacts on the real economy.

A better way of looking at it is that banks are lending to consumers because that is the easiest way of making profits at present. Real wages are stagnant, lending creates rising asset prices, and the bubbles that result are the way of sustaining lending and giving an appearance of profitability. Ultimately, though, banks increase their profits out of wages and salaries. The figures for the share of individual disposable income appropriated by banks in the US in recent years are telling. According the Federal Reserve, the average share of disposable personal income used to meet debt service payments has risen steadily from 15.6 percent in early 1983 to 19.3 percent in June 2007.
 

And the reason is that there are fewer profitable outlets for financial capital in production?

I would be careful in phrasing it like that. It is not so much that real accumulation does not generate enough profitable avenues for banks to lend. Rather productive capitals can increasingly meet their financing requirement either by retaining profits or by borrowing directly in open markets for bonds and other instruments. This is very clear with Japanese companies that have historically relied on big banks for finance. If they want external finance for their investments now they are more likely to issue bonds in international markets. Banks have been edged out of this business, and have to seek other avenues of profitability for themselves.

It should also be mentioned in this context that banks make substantial profits out of individuals by managing bank accounts, transferring money, making payments, keeping money safe, and so on. These are simple money-dealing activities.

In short, over the past ten to 12 years banks have been very profitable. They have appropriated large parts of the wage and salary income of ordinary people, either by lending to them or by managing payments and deposits. It is natural to ask, “Have the banks at least been efficient in their banking activities while doing this?” And the answer is that there is no evidence at all of such efficiency. Indeed, mainstream empirical studies of banks in the US and the UK show consistently that banks are inefficient and very expensive. Anyone who has tried to send money abroad from the UK through a bank will know what I mean.
 

Martin Wolff and various other writers in the Financial Times have been quoting figures from an IMF study from two years ago about global balances. Essentially they see the root of the crisis as being in the transfer of funds from East Asia across the Pacific to the US – and now a transfer of funds from US firms who put money into financial markets – which creates a mass of cash looking for outlets.

That is a very important part of the total picture. We know that on a global scale certain key countries have been generating enormous surpluses – China mainly, India on a much smaller scale and increasingly in the past two to three years the oil exporters, Russia and the Gulf countries. The oil exporters collectively have now possibly overtaken China. These financial surpluses are generated from balance of trade surpluses. This, again, as far as developing countries are concerned, is a novel and pathological phenomenon, with the exception of the oil exporters. Developing countries should not chalk up balance of payments surpluses at early stages of their development because such surpluses mean they are accumulating savings in excess of investment. That is not how capitalist development should be taking place. That is certainly not the way to expand demand and create jobs in countries that contain vast poverty.

Nonetheless, these surpluses have gone abroad, mostly to the US, where savings have collapsed and consumption is at unprecedented levels in relation to income. The bulk of the surpluses went into government bonds bought by the central banks of developing countries. Such funds represent a form of lending by several poor countries to the US state. However, significant volumes also appear to have gone into securitised assets, thus ultimately supporting the explosion of securitisation and subprime lending.

One implication of this is that the crisis is truly global. Deeply problematic assets are held by financial institutions across the world now. It is not simply the US. We cannot at the moment know the extent to which this has occurred. It will only become clear as the crisis unfolds.

The financial crisis is probably a milestone in the reversal of these deeply pathological global flows of capital. My expectation is that American savings will rise quite significantly in the near future. The spending spree in the US will effectively come to an end. Already the US external deficit is declining as the US balance of trade is improving and US exports are rising. The proximate cause of this, of course, is that the value of the dollar has collapsed.

The implications across the world are not easy to gauge. But it seems clear that the dollar will continue to pay a price, and this will have implications for American hegemony. Already the very large sovereign funds of the oil producers – which manage the surpluses accumulated in the last two or three years as oil prices have gone through the roof – are making noises about diversifying away from the dollar, buying assets denominated in yen or euros. If this were to happen on a large scale, then the position of the dollar as the prime reserve currency would suffer greatly.

Interestingly, it looks as if the US ruling class does not consider that to be the main danger it faces at the moment. To me this is the most striking aspect of what the Federal Reserve chairman, Ben Bernanke, has done in the past couple of months. Faced with a domestic crisis and a precariously placed dollar, he chose to abandon the dollar. This is an indication of the fear that the US ruling class feels at the moment – fear that the domestic economic situation is out of control and that they might as well run the risk of the dollar sliding and losing some international purchase if they are to preserve the domestic economy. Whether they are right in making this judgement is a different issue.
 

If spending by US consumers falls, won’t this have a big impact on economies such as China’s, which seems to be based largely on exporting to the US?

I am reluctant to go into that because, to a certain extent, the domestic concerns of China are driven by other determinants. At some point the Chinese ruling class will have to face the problem of insufficient domestic demand. How they are going to do that, I do not know. Possibly the tightening American market will encourage them to redirect their efforts to the domestic economy.
 

This is the whole discussion in the Financial Times about “decoupling”.

My knowledge of the Chinese economy is not that detailed, but I do know that, according to Chinese figures, investment spending is enormous. The possibility of expanding investment further is probably not that great. On the other hand, increasing consumer consumption requires substantial income redistribution, a different approach to welfare, altered provision of public goods and so on. In short, it involves a complete rethinking of how the Chinese state relates to the working class. Thus it poses deep political questions and is not at all easy.
 

Could you expand on the role of central banks and their connection to the state?

We have lived through three decades of liberalisation and globalisation. What we hear from the financial institutions and everyone associated with them is that the state is insignificant, that the state cannot buck the market, and various other platitudes. But the moment there is a crisis they go cap in hand to the state and ask to be rescued, as has happened in Britain with the collapse of Northern Rock. So obviously the argument about the state being insignificant is ideological. The real issue is to understand how the state operates today, how its role has changed.

The central banks are very important in this connection. The state and the ruling class have been very clever. Central bank independence – that is, separating monetary decision making from the electoral process which provides some kind of scrutiny – was a clever move on their part. Monetary policy has become the exclusive preserve of specialists and is not for the public to discuss. That is nonsense. Just as tax policy is subject to public debate, popular demands and class struggle, so should monetary policy be.

One thing which is not properly appreciated in this connection is that, despite all the deregulation of the last 20 to 30 years, the monopoly of the central bank over the final means of payment has been unchallenged. There might have been incredible financial innovation, but only the central bank is allowed to issue legal tender, into which all other money ultimately converts. In other words, the free market ideology wants free markets in everything except in money. This is the deepest contradiction at the heart of neoliberalism. If you are a true neoliberal, if you really believe that the market is such a great thing, then you should also let it organise money, because money is a key commodity in a capitalist economy. Why should there be a free market in everything except in money? There is ultimately no logic in neoliberalism. When it comes to this question, mainstream economists simply treat anyone who wants to leave the issuing of money to the free market as a crank. But if you point out that, since there is regulation of money, why not also regulate the economy more generally, you are called “extreme”.

And so the money market is completely dominated by the central bank, which issues legal tender and thus supplies other banks with liquidity. That gives the central bank enormous power within the financial system. For central bank money is what all the other institutions must have in order to settle their accounts. It is the ultimate embodiment of value, as Marx said of money more generally. By controlling its supply the central bank can decisively influence interest rates across the economy.

But I should stress that, though the central bank is currently very powerful indeed – probably more than at any other time in the history of capitalism – this does not mean that it can take action at will. The weaknesses of central banks, the limitations on their power, became very clear during the disaster of Northern Rock. The provision of money and liquidity to banks had to obey external pressures from the market, and had to operate within a very narrow frame that carried risks for all involved. I do not think that the Bank of England came out of this with flying colours, its actions probably accentuating the shortage of liquidity and exacerbating the run on Northern Rock.
 

The Japanese example seems to prove that the ruling class can get into a hole that they find it very difficult to get out of. The second most powerful capitalist class, and a very self-contained capitalist class, spent 15 years not getting out of the hole. There have been vague worries among some of the Financial Times writers about the US ruling class getting into the same situation. Or look at Northern Rock. It’s incredible that the British government could lose half the money that it put into Northern Rock. It implies the situation is much more serious than some of us thought in August. You are saying there are limits to what the state can do in this situation.

The central bank is a bank. It might sound far-fetched but central banks can go bankrupt. At the very least, they cannot keep acquiring assets that are worthless because their own balance sheets begin to look very bad. This has a bearing on the Bank of England and Northern Rock. It has made loans to Northern Rock against the security of Northern Rock’s assets, which are nothing but various mortgages and other loans that Northern Rock made in the past. If the assets of Northern Rock became worthless, the Bank of England would lose an enormous amount of money. It certainly could not contemplate lending on similar terms to two or three more banks, without seriously compromising its own health.

Now multiply this by a large factor and you will see the problem that Ben Bernanke might potentially face at the Federal Reserve. US banks have acquired so much questionable paper over the past few years that they are now sitting on a mountain of it. They have already written off $50 billion and estimates of further bad debt vary from $200 billion to $500 billion, to wild guesses of trillions of dollars. Depending on how the crisis unfolds, they will need additional finance to deal with the problem. The Federal Reserve cannot directly supply such finance, though it can play a key role in organising. Ultimately, of course, other arms of the state could step in, provide additional finance, forgive loans, and so on. But these are last resort interventions that typically have major political and institutional costs. This is not something that the ruling class wants to face because it reveals the nature of class power very clearly and there are no guarantees of smooth resolution.

To put it differently, central banks are pivotal to the current crisis, but they cannot necessarily see a way out of it in the short run. This is a classic example of contradictory capitalist development. At the moment of the central bank’s greatest power one also sees its phenomenal weakness. Bernanke looks like a pathetic windblown man who does not know which way to turn. This is not down to his own personal deficiencies compared to Alan Greenspan. He is certainly far better qualified academically than Greenspan. No, it is the nature of the storm that is surrounding him.

I want to add one last thing, a point that I have made indirectly before. I think that the left should insist that credit and monetary policy constitute a legitimate field of criticism, inquiry, public debate, class struggle and radical demands. Monetary policy is fundamental to contemporary capitalism. Precisely because of the increasing autonomy of the financial system, because it has become so huge, finance has arrogated to itself the making of monetary policy, declaring it a matter for the experts. Meanwhile, the price for the mess created by finance is paid by ordinary people in the US, Britain and elsewhere. The left should stress that ordinary people are entitled to a more rational organisation of financial affairs that takes their own interests to heart. They also have a democratic right to exercise scrutiny and control over credit and monetary policy.

 
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