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Mainstream, Vol XLVI No 45

Collapse of the Financial Institution of American Capitalism

Monday 27 October 2008, by P R Dubhashi

The first two weeks of September saw the collapse of American giant financial institutions which fell, one after another, like nine pins. Actually earlier in March itself, the fall of Bear Sterns, the third or fourth large bank, itself was an indication of the shape of things to come. The bank was taken over by the American Government but then itself it was feared that the salvage of the bank was not enough and the rot would not stop. Rumours started floating that yet another bank would follow suit and that turned out to be another big investment bank, the Lehman Brothers. This time the government chose to take a tough stand on the ground that the bank should bear the consequences of its wrong financial transactions. However, what was “sauce for the goose was not sauce for the gander”. A few days earlier two other huge financial institutions—Fannie Fae and Freddie Mac—were taken over by the government. These two are actually not lending institutions but guarantors of mortgage loans. The government justified its action on the ground that if the guarantors failed, it would pose a threat to the entire mortgage loan business. Another big blow followed: AIG (American Investment Group), the biggest insurance company with worldwide network, also faced financial bankruptcy. It was salvaged by the Federal Reserve Bank which undertook to lend up to 80 per cent of its financial burden in return for government ownership of stocks of the company in the same proportion.

Thereafter it was the turn of three other reputed investment banks—Merrill Lynch, Goldman Sachs and Stanley Morgan Investment. The former was taken over by the Bank of America while the latter two were converted into holding companies. Next on the chopping block was Washington Mutual, biggest bank taking deposits from and lending to ordinary clients. This too was nationalised.

The American Government and the Federal Reserve soon realised that dealings with individual financial institutions as and when they collapsed was not the right way to stem the tide. Each fall of these big institutions had created a panic situation in the entire financial world. The repercussions of the fall of the financial institutions were felt in the entire economy. There was loss of confidence. Banks would not lend to each other or enter into transactions. The entire credit system was under the threat of being frozen. There was fear of recession. The situation had to be tackled as a whole.

IT was in such an emergency situation that the American Treasury Secretary, Henry Paulson, in consultation with the Governor of the Federal Reserve, came forward with a big “bailout plan” of $ 700 billion. President Bush came out on the lawns of the White House to take the people and the press into confidence regarding the bailout plan. What America was faced with an unprece-dented situation which required an unprecedented solution to tackle it. The ‘plan’ provided the solution. Bush added that the Treasury Secretary would enter into discussion with the Congres-sional leaders of both the parties to pass the necessary legislation to sanction the plan. President Bush urged upon the leaders to pass the legislation on an urgent basis.

But the Congressional leaders were not in a mood to act immediately to the President’s bidding. The Democrat members of the Congress squarely blamed the Republican Administration for following policies which led to the financial mess. They particularly blamed the Treasury Secretary, Paulson, for weak or non-existent regulation of the financial institutions. Being himself an erstwhile “Wall Street Mughal”—he was the Chief Executive of Goldman Sachs before he became Treasury Secretary—he gave a free hand to the financial institutions and their CEOs. Now he could not be trusted with $ 700 billion in the name of the “bailout plan”. The public opinion was also very adverse. Why should the taxpayer’s money be used to pay for the cost of the blunders of the CEOs of the financial institutions who failed in the discharge of their duties? What is worse, as some of them walked away with hefty terminal benefits running into millions of dollars, the common man lost his residence and came on the street if he failed to repay the loan installment on time; but the CEOs went scot-free.

The Republicans were also reluctant to use the taxpayer‘s money for the bailout plan. They indeed had basic ideological objections. Since the days of Ronald Reagan, the Republican Party had vehemently upheld the gospel of the free market economy with minimum state intervention. This was the gospel preached by the free market “guru” and leader of the Chicago School of Economics, Prof Milton Friedman. According to this gospel, the market is always right and efficient too. If there were to be any problems, the market itself would provide automatic solutions. The government cannot provide solutions since every government intervention was a problem, not a solution. Under Milton Friedman’s influence, the Republicans had banished all types of Keynesian interventions which for them became an anathema.

The more radical thinkers like Naomi Klein characterised the plan of Bush Administration as an example of “socialism for the rich“ while it preached “capitalism for the poor” according to its concept of minimal state. The poor victims of the storm Katrina who had lost their houses and belongings had fully experienced the misery caused to them by capitalism under which in the name of rehabilitation they were exposed to the hired contractors to provide houses, which were left half built after the contractors deserted them. There was no public agency to provide housing or education.

The leaders of the developing countries also looked askance at the behemoth bailout plan. When the Latin American and African countries were in dire straits and when there was the “Asian meltdown” in 1997, America and under its influence the IMF and World Bank were vehemently opposed to any “bailout” plan since it was inconsistent with the principles of a “free market economy” which was at the core of its uniformally prescribed “structural adjustment programme”. But when there was a meltdown in America, a hefty “bailout plan” came out!

Looking at the reception given to the bail out plan of his Administration, President Bush came out thrice to persuade the reluctant Congressional leaders to support the plan. His “bailout plan” now became a “rescue plan”, not bailing out institutions but rescuing an economy under siege. He said that the Wall Street crisis would engulf the whole economy unless checked on time. He also tried to muster the support of the American people by saying that their own fortune, their ability to get credit to support their lifestyle would be atrophied if the crisis was not gotten over.

BUT Bush was in for yet another shock. When the Bill to support the plan came before the House of Representatives it was decisively defeated. Not only 96 Democrats but two-thirds of the Republicans voted against the Bill. This was a resounding slap. Bush expressed grave disappointment and sat with his economic advisors to find a way out. He was able to get the Senate approval and again brought the Bill before the House of Representatives. This time he succeeded in bringing to bear enough pressure to get the Bill passed. But not before a number of clauses were added which turned a three page document, submitted by Henry Paulson, into a lengthy document running into 104 pages. It incorporated clauses to provide assurances to assuage the anxieties expressed. First, there would be a House Committee mechanism to “supervise” the implementation of the plan. They did not want Henry Paulson to be left to himself. Second, they wanted to limit the CEOs remunerations and their benefits which had gone haywire at the cost of ordinary investors. Third, they wanted provisions to compensate the taxpayer for his sacrifices, as and when the economy improved. The implementation of the plan and bringing it to a successful conclusion would not be easy. Paulson has entrusted it to one of his young assistants, Neil Kashkari, a person of Indian (Kashmiri) origin.

In the meanwhile, the ramifications of the American crisis spread to Europe as well. Britain saw one of its big Banks, Bradford and Bingly, failing. The government took it over as it did last year when Northern Rock failed. This was followed by financial crises in the Bank of Scotland, HBOS, Lloyds, TSB Barclays to which the British government extended a support of £ 50 billion. Fortis, a big bank in Belgium, started falling despite sound business and had to be taken over by the combined support of the Government of Belgium, Netherlands and Luxemburg. A Scandinavian country, Iceland, saw a complete meltdown of its banking system. Its President had a heart attack and its Prime Minister asked
his people to go back to fishing. The German Government gave a support of $ 50 billion to its banking system. The European Central Bank serving the entire European Union also came out with its plan.

But despite the approval of the mega plan, the confidence in the stock market was not restored since the plan was considered inadequate to salvage the situation. Dow Jones plunged, so did the European and Asian stock markets.

America now decided to muster the support of all the world to support its tottering financial system. The Treasury Secretary met with the Finance Ministers of the G-7 countries and came out with a five point plan. He also sought the support of the G-20 countries including India.

President Bush and Henry Paulson were candid in admitting that despite the plan, the recovery would be slow and recession could not be averted easily. The gravity of the situation was widely recognised. Warren Buffet, one of the top American billionaires, described the calamity as America’s financial Pearl Harbour. Many called this the greatest calamity after the 1929 depression. From the position that everything was OK with the triumphant American capitalism, the American policy-makers had to climb down to the position that there were “systemic defects” which had to be identified and removed. This, despite the realisation of the gravity of the situation, the American policy-makers have failed to do so far. They have yet to make a candid analysis of what went wrong.

THE proximate cause of the financial crisis in US was the phenomenon of sub-prime lending for housing by land mortgage credit institutions. Many of these loans turned “toxic” because of the failure to repay the loan instalments. As the failure to repay became widespread it was noticed that the institutions resorted to reckless lending without insisting on the necessary down payment and proper examination of the repaying capacity of the borrower. The lending banks were confident that the loans were secure because the values of the real estate for whose purchases loans were given were continuously rising. When the real estate values started falling, the assets turned “illiquid”.

The recklessness of the lender was stimulated by the recklessness of the borrower. Every American was carried away by the “American dream” of a huge luxurious house in the suburb even though it required commuting over a long distance to reach the place of work involving additional expense of transport which started mounting with rising petrol prices. Americans craved for luxurious living beyond their means and this addiction to high consumption was facilitated by credit institutions ever willing to lend at low interest rates and the ubiquitous credit cards which encouraged spending sprees at the supermarkets. A century ago Thorstein Veblen had drawn attention to “ostentatious living” by the leisure class. Now it tended to be a universal feature of the American society.

Cheap lending in turn was facilitated by the low interest policy assiduously promoted by the past Chairman of the US Federal Reserve, Allen Greanspan, over his long tenure.

The country itself was living beyond its means. It ran huge budget deficits, and external deficits thanks to the surpluses of vigorously exporting country like China which were parked in dollars in the American financial system. US debt has risen to two-and-a-half times the nation’s GDP, and is approaching $ 44 trillion of the entire world.

The illiquidity of the real estate lending sector extended far beyond it and enveloped the entire financial sector because of the “securitisation” of the mortgages, trading in derivatives and futures and operations of the hedge fund which encouraged financial speculations on a large scale. This huge superstructure of a financial system with worldwide operations was facilitated by the new computer technology and instant internet communications. The financial superstructure started operating on its own steam unrelated to the “real economy”. This was rightly characterised by noted economists, Henry Magdoff and Paul Sweezy, as “financial capitalism” covering the whole gamut of investment banks, hedge funds and stock markets.

The CEOs of these financial institutions were the new “mughals” whose insatiable greed led to reckless financial operations in complete disregard of the productivity in the real economy. The goal was “maximisation of profit” in the short run and not sound long term development. Concepts like honesty, loyalty to an institution and sound business became old fashioned and disdainfully discarded. The greed of the CEOs soon turned into personal acquisition in an unscrupulous fashion. They awarded to themselves hefty compensations in various forms including salaries, perks, bonuses and stock options. The CEOs deserted the investors they were serving at the first opportunity after making a fast buck. They did not hesitate to indulge in fraud in which they were joined by reputed accounting firms; as was brought out in the Enron case whose fabulous boss, Kenneth Lay, a favourite of President Bush, had to end his last days in jail undergoing a sentence after the scandal came into open and the firm collapsed. The FBI disclosed that CEOs of some of the financial institutions which recently collapsed are under investigation for deliberately misleading the investors. While giving them assurances regarding the bright prospects of their companies in their private communications on the internet to each other, they were talking of impending financial collapse.

As a result of the greed of the CEOs of the American corporations, the gap between the top and bottom of the society in financial wealth and income has reached astronomical proportions

Financialisation of American capitalism began in 1960 and became prominent by 1970. The main characteristic of the change was the increasing role of finance in the operations of capitalism. Economist James Tobin, a Nobel Prize winner in 1981, drew attention to the “Casino aspects” of the financial markets. Financial activities, remote from production of goods and services, generate high private rewards disproportionate to their social productivity. Thanks to the computer power, the “paper economy” of financial exchange ballooned in quantity and variety. As a result “speculative bubbles” and stock market crisis have become a recurrent and growing problem.

How and when American capitalism and its European counterpart would be able to overcome the current financial crisis is yet to be seen. The vigorous implementation of the bailout plan and the coordinated worldwide efforts may succeed eventually. But one thing is clear: American capitalism and its ideology have received a big blow. No longer would the arrogant claims of Francis Fukuyoma that American capitalism marks the “end of history” carry conviction. Capitalism is not perfect. It has no magical qualities to correct itself and state intervention is not a taboo. Indeed capitalism is perforce required to take the help of the state to survive. The logic of free market capitalism that pursuit of profit invariably redounds to public good has turned out to be “Adam’s fallacy” (reference to Adam Smith’s “invisible hand”). Unbridled capitalism is not the last word. Capitalism may not have ended but surely it has to be mended.

WHAT does a country like India learn from the experience? The Indian Prime Minister and Finance Minister, both keen “reformers”, were anxious to insulate the Indian economy from the American and international crisis. The tumbling stock market and severe liquidity crunch have forced the government to take suitable measures to provide liquidity. Already CRR, which was raised to curb inflation, has been brought down thrice. But even this appears to be inadequate. But what happens to inflation? And would India continue to maintain a high growth rate above seven per cent? The FM would like to be optimistic. But the export and service sectors may get hit and adversely affect the growth rate.

The impact on the Indian economy would have been much more severe if the Indian financial system had been more exposed to the international system. This would have happened if the so-called “reforms” of the banking and insurance sectors with greater privatisation and foreign equity investment and pension fund investment in stock markets, which were dear to the Finance Minister, were allowed to take place. This could not happen thanks to the resistance of the Left. They became the obstructers to “financial reform”. But for their obstruction, the crisis in India would have became more severe but the Finance Minister and other die-hard reformers are not prepared to acknowledge it. The capital account convertibility and more deregulation of the financial system might have proved dangerous.

This is the lesson that the Indian economic reforms should learn from the current crisis. Hereafter blindly following the reform process and structural adjustments dictated by the IMF, World Bank and American treasury would be a recipe for disaster. India should pay greater attention to the real reforms—the rejuvenation of the agricultural and rural economy, improving the infrastructure, education and health services, more active role of the state through improved machinery of administration (rather than outsourcing everything) and checking growing inequalities and disproportionate earnings in the luxury and speculative (non-productive) sectors.

Dr P.R. Dubhashi is the former Vice-Chanceller, Goa University, and an erstwhile Secretary, Government of India. He can be contacted at e-mail: dubhashi@giaspn1.vsnl.net.in

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