How low will it go?

November 3, 2008

Lee Sustar looks at how the financial crisis has hit the underlying economy--which makes further financial shocks more likely as a world recession takes hold.

THE STATISTICS are finally showing what everybody knew: the U.S. economy is already shrinking, and dragging the rest of the world down with it.

The government reported that the U.S. economy contracted by 0.3 percent in the third quarter of this year--a figure that's likely to get worse when it's revised on the basis of more complete data in a few weeks.

And these figures for gross domestic product (GDP)--the broadest measure of output of goods and services--were for the period of July through September. Thus, they don't reflect the full impact of the financial panic that locked down the credit system worldwide since then.

Other data, in fact, show the likelihood of further decline. Consumer spending in the third quarter fell at an annual rate of 3.1 percent, the worst such drop since 1980, when the U.S. was in the grip of high inflation and about to enter the worst recession of the post-Second World War era.

What about that $700 billion Wall Street bailout pushed through Congress by Treasury Secretary Henry Paulson?

When the rich get in trouble, they can rely on governments to bail them out

The truth is that the so-called Troubled Asset Relief Program (TARP) was never really intended to prop up the broader economy. The aim was to rescue failing banks by handing them taxpayers' money.

Plan A was to use TARP money to buy up bad mortgage-backed securities and clean up the balance sheets of the banks. Plan B was to use $250 billion for the government to effectively nationalize the nation's biggest banks--a move carried out only after European governments carried through more decisive bank nationalizations themselves.

The U.S. government had already taken over the huge mortgage companies Fannie Mae and Freddie Mac and insurance giant AIG. Yet it was Paulson's refusal to nationalize the investment bank Lehman Brothers in mid-September that turned the financial crisis into a full-fledged panic.

Lehman was a major player in several obscure financial markets, such as money market mutual funds, which in turn were the primary players in loans known as commercial paper to major corporations to meet daily needs like payroll. Lehman's failure led to a virtual shutdown of this market for commercial paper, creating a worldwide credit lockdown.

It was in this context that Paulson made his bailout power grab. Paulson justified the unprecedented transfer of wealth from workers to the banks under TARP by claiming that the money would enable the banks to resume lending to one another--and to businesses and consumers. In fact, most of the banks are sitting on the funds or using them to finance takeovers of weaker competitors, such as the proposed takeover of National City by PNC. Another provision of the TARP allows the acquiring bank to take a tax write-off on the losses of banks they take over.

"It is starting to appear as if one of Treasury's key rationales for the recapitalization program--namely, that it will cause banks to start lending again--is a fig leaf, Treasury's version of the weapons of mass destruction," wrote New York Times business columnist Joe Nocera. "In fact, Treasury wants banks to acquire each other and is using its power to inject capital to force a new and wrenching round of bank consolidation."

What's more, the banks have already set aside an estimated $40 billion for executive bonuses for this year, according to the Wall Street Journal. While political considerations might mean that the bonuses aren't paid out, the question remains: Why do they need the bailout money if they've got so much cash anyway?

BESIDES THE TARP con game, there's an effort to flood the banks with practically unlimited government loans through the Federal Reserve Bank. But that hasn't been able to halt the economy's slide, either.

Since the world financial crisis began nearly a year and a half ago, the Fed has slashed interest rates from 5.25 percent to, as of last week, 1 percent. At the same time, it has steadily expanded the kinds of loans it will make--to investment banks, money market mutual funds, sellers of commercial paper and more--all while accepting practically anything as collateral, including bad mortgage-backed securities.

The Fed has also made an unlimited amount of dollars available internationally for currency swaps with foreign banks. According to the estimate of former banker and author Charles Morris, the Fed injected some $1.6 trillion in liquidity into the financial system in September and October alone.

Flooding the financial system with money, however, doesn't guarantee that banks will resume lending--certainly not on the scale necessary to revive the economy anytime soon. That's the lesson of the Japanese economy of the 1990s in the aftermath of that country's real-estate bubble.

The Japanese central bank cut interest rates to near zero, but that didn't lift the economy out of a recession. Instead, Japan fell into the grip of deflation--falling prices for goods and services--which further suppressed economic growth. It's called a "liquidity trap"--no matter how much money is available to borrow, the downward spiral of prices makes it extremely difficult for companies to make profits.

So businesses don't borrow or invest--and they don't create jobs. Economic activity slows, unemployment rises, and goods pile up unsold until prices are cut, intensifying the downward cycle.

Today, only four months after food and fuel prices reached record highs, the threat of deflation hangs over the U.S. and the world economy as the recession stifles demand for everything from raw materials to cars to electronic goods. As of October 31, the price of oil hit about $68 per barrel, a drop of more than 50 percent since July.

Steelmakers, who months ago were making huge profits as they struggled to keep up with orders, report a sudden, sharp drop in demand. According to a Chinese steel industry analyst, half the steelmaking capacity has been shut down in China's Tangshan region, which has the world's biggest concentration of steel mills.

THE FALLING prices point to the underlying cause of the world economic crisis--overcapacity and overproduction. Not only is there too much steel, too many cars, too many ships, etc., to be sold at a profit, but there are too many factories that produce them.

To capitalists, it's irrelevant that there is a desperate need for industry and industrial goods in the poorest nations and the run-down areas of the developed countries. The issue is whether or not profits can be realized. "Excess capacity" must be wiped out through bankruptcy or other means in order to restore the rate of profit.

In recent years, the huge growth of debt throughout the system postponed the day of reckoning, as borrowing helped companies hide their losses. But now that the mountains of debt are crumbling, this is no longer possible.

As the New York Times' Peter Goodman explained:

Global economic growth has flourished in recent years, much of it fertilized with borrowed investment. This raised kingdoms of houses in Florida and California, steel mills in Ukraine, slaughterhouses in Brazil and shopping malls in Turkey.

That tide is now moving in reverse. Banks and other financial institutions are reckoning with hundreds of billions of dollars worth of disastrous investments. As they struggle to rebuild their capital, they are halting loans to many customers, demanding swift repayment from others and dumping assets--homes sold out of foreclosure, investments linked to mortgages and corporate loans. Selling is pushing prices down further, making the assets left on balance sheets worth less, in some cases, prompting another round of sales.

The deepening of the recession could trigger another, potentially even more devastating, phase of the financial crisis. That's because large corporate bankruptcies--inevitable as the downturn goes on--will trigger so-called credit default swaps (CDS).

These arcane financial instruments are essentially insurance policies. If an investor thinks that ABC Company may default on its bonds (loans), the investor can buy a CDS to cover any potential losses. If ABC Company goes under, then the investor gets paid, just as a car owner is paid by an insurance company if his or her car is totaled in an accident.

In the unregulated CDS market, the complication is that investors bought these swaps even when they didn't own the underlying bond. Essentially, they were betting on the failure of ABC Company in order to get paid if it went down. This form of speculation is so widespread that that the market for CDS is estimated at between $52 and $60 trillion, more than four times larger than the annual economic output of the U.S.

Many of these investments in CDSs were made with borrowed money. So in the event of a bankruptcy, companies obligated to pay up to cover those CDSs often don't have the money to pay it back. That's a factor in the huge swings in the stock market, as private investor groups known as hedge funds sell off shares to cover their obligations. Another key factor in the CDS market chaos is the failure of Lehman Brothers, which created a cascading wave of payment obligations on CDS contracts.

CDSs are only one kind of the dangerous financial instruments known as "derivatives"--that is, a financial investment with a value "derived" from an underlying stock, bond or other security. As the New York Times reported November 2, municipal governments, school boards and other government entities across the U.S. invested in derivatives to try to cover pension and retiree health care obligations, but they are facing huge losses as those investments--and the banks that sold them--go down.

As the financial system unravels, U.S. workers face mounting difficulties. Joblessness is now officially 6.1 percent, but when the figure is broadened to include those working part-time who would rather work full-time and other so-called "marginally attached" workers, the unemployment/underemployment figure for September was 11 percent, the highest such figure since records were first kept in 1994.

And the housing crisis, the spark for the wider financial debacle, shows no sign of abating, with at least 7.5 million homeowners now owing more on their mortgage than their home is worth--around 18 percent of all properties. Another 2.1 million homeowners could soon be in the same position as home prices continue to fall.

BAD AS the situation is for the U.S. economy, the prospects for the rest of the world are worse.

As governments in the U.S. and Europe step in to guarantee or nationalize their banks and other financial institutions, pressure has mounted on poorer nations, from Eastern Europe to the newly industrializing countries of East Asia. These countries lack the economic clout to mimic the state capitalist strategies pursued by the U.S. and European countries.

Plus, the enormous losses on world stock markets--$9.5 trillion in the month of October alone--has led investors to pull out of these markets and put their money back into the U.S. and Europe. The economies of countries like Hungary, Ukraine and Iceland have been shattered--and that list will soon grow longer.

As a result of this financial crash, the International Monetary Fund (IMF)--which insisted on terrible austerity measures in the 1997-98 financial crisis--is back in business, offering loans to hard-pressed countries.

In recent years, wary nations avoided the IMF and stockpiled foreign currency reserves to protect themselves from a financial crash. But the crisis has hit so widely and so fast that those reserves are being quickly depleted.

Mexico, for example, spent more than $13.1 billion in a bid to defend the value of its currency, the peso. Even Russia, with foreign reserves that peaked at more than $500 billion, finds itself quickly burning through that cash to try to defend the value of its currency, the ruble. Meanwhile, foreign investors pulled $72 billion out of Russia in October.

Even if these so-called "emerging market" countries survive the financial shockwaves, they're likely to find themselves dragged down by the recession in the U.S.

Not long ago, there was a popular theory in the business media that the world economy could "decouple" from the U.S., thanks to the economic rise of China as well as Brazil, India and Russia. Today, however, China's economic engine is slowing. While its growth rate is estimated at 9 percent, that's down from 12 percent only a few months ago--and with demand for Chinese imports on the downswing in the U.S., China's growth is likely to slow further.

That's bad news for exporters in Germany, Japan and South Korea, which provided China with machine tools and high-tech equipment, and for Latin America, which boomed in recent years on the basis of its raw-material exports to China.

To be sure, China has a cushion of $1.8 trillion in foreign currency reserves--much of it in U.S. dollars--to stimulate its economy in an effort to cope with the drying up of export markets. But China's vast industrial expansion since the 1990s was predicated on continued demand from the U.S. and Europe. With these markets curtailed, problems of overcapacity and unemployment will mount, and with them the likelihood of the strikes and protests that have periodically erupted in recent years.

Far from decoupling from a crisis-ridden U.S., the world economy is linked to it more tightly than ever. The economic crisis--and the resulting ideological and political crises--will be international as well.

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