Question

Political Economy Question:

Describe the empirical trends leading up to the 2008 crisis-was it caused by the financial crisis or was the financial crisis a crisis within a crisis?

Answer 1

2008 Financial Crisis was a crisis within a crisis

Introduction

According to Kindleberger (1978) ,financial crisis are usually caused by any exogenous shock in the economy that results in displacement in the expectations that results in one of the sectors of the economy to be looked as a promising sector; this triggers speculation in this sector causing the price of that particular asset to rise. Later this phase of ‘mania’ transitions into phase of ‘euphoria’ wherein speculators overinvest in the asset of that particular sector along with financial institutions expanding credit in that sector accompanied by loosen credit norms. In addition, banks over leverage their balance sheet beyond a permissible level and even start lending to borrowers with poor credit history and low paying capacity due to their belief that the prices of the underlying asset would always rise thereby ensuring their repayment of loans.

When this debt driven speculated bubble inflates to its maximum, insiders start to sell their assets and drive the price of the asset down.(According to Kindleberger, there are two agents in the economy-insiders and outsiders, While insiders are the agents who are first to enter and exit that particular sector ,outsiders are those agents who are worse hit by the speculative bubble since they enter and exit late).With the spread of the news of liquidation of that particular asset by the insiders to other financial agents ,there is a rush for other agents to join the movement of liquidation because of their belief that price of the asset would not rise further, Kindleberger calls this as revulsion phase.

This drive for liquidation by the agents results in the fall in the price of the underlying asset followed by rise in the number of default in loan payments by the borrowers followed by the phase of Discredit wherein banks stop their lending to this particular sector because of their stressed balance sheet.

Phase of Revulsion accompanied by the discredit phase leads to burst of the asset bubble thereby triggering panic in the economy which ultimately leads to financial crisis.

This year marks the tenth anniversary of the collapse of the Lehman Brothers, which triggered the Global Financial Crisis and is the worst economic disaster since 1929.This crisis led to widespread unemployment ,recession ,destruction of equity and housing wealth.

The real reasons for 2008 financial crisis are:-

Dependence on financialization to lift the stagnating monopoly capitalist system

United States is an economy with giant monopolistic and oligopolistic corporations. This system is constrained by chronic lack of effective demand for the produced good. The causes of lack of effective demand in the advanced capitalist economy arises because of the sluggish consumption demand of the working class which is a result of exploitation of the workers in the process of surplus generation as real wages of the workers rise less in comparison to increase in the productivity of the goods accompanied by decrease in the investment by the capitalist class due to already existing idle capacity in their economy and lack of profitability in the market.

United States like other advanced capitalist economy faced stagnation in the real economy from early to mid 1970s and this crisis happened after prolonged period of growth and stability in capitalism; However, the growth in the golden phase of capitalism was a result of rise in the military spending in Korean and Vietnamese war which compensated for the decline in the share of government consumption and investment spending in the G.D.P. But in the early 1970’s the external stimuli were insufficient to prevent the advanced capitalist economies like U.S.A which is characterized by monopoly capitalism from stagnating.

Since 1970s, U.S real economy was stagnating and monopolistic corporations in U.S faced vanishing investment opportunities in such circumstances financialization was considered as the only panacea to lift the stagnant monopoly capitalist advanced economy with the existing wage share in the economy, through the employment creation in the Finance, Insurance and real estate sector and also by creating an additional demand in the economy, without any changes in the class relation, because any speculative credit driven boom generates wealth effect in the economy and hence additional demand .Moreover, these speculative bubbles provide an opportunity for the wealthy to grow their money capital .Hence, there was a shift in the policies in the advanced capitalist economy from 1980’s & 1990’s to Financialization , it can be defined as the shift in the focus of the capitalist economy, from production to finance which was further aided by financial liberalization of the developing countries.

Furthermore, U.S enjoys a hegemony in finance viz-a-viz other emerging market economies as it has been receiving cross country funds from oil exporting countries since 1970s; further due to east Asian crisis developing countries are holding significant amount of U.S treasury bills to build their reserves as a cushion against sudden capital outflows from their countries which could be destabilizing for their currency. Moreover, with China becoming the factory of the world there is a cross border flow of funds from China to U.S.A whose current account surplus is financing U.S growing current account deficit. The ample flow of funds to U.S can help it finance any credit driven growth to boost its economy.

The other reason that pushes financialization is a further rise in inequality in the advanced capitalist economy post 1970 due to rise in the efforts by the government to control the power of the workers union along with their efforts to reduce the income of the working class .Moreover, post the opening up of the developing countries ,particularly China accompanied by stagnating manufacturing base in advanced capitalist economies has resulted in loss of thousands of factory jobs in U.S.A ,and has further weakened the bargaining power of the working class in developed advanced capitalist countries. Although globalization resulted in rise in the creation of high paying skilled jobs, but Americans could not switch to these skilled jobs as these high paying jobs created post opening up required college education, which was not within the reach of an Average American as there was a continuous slash of funds of public universities along with rise in their tuition fees. However, American tax policy was regressive in the Reagan administration that further increased the inequality in U.S.A.

Since majority of American working class were trying to survive on their stagnant wages this could have resulted in the stagnation of the monopoly capitalistic economy .Hence there was a push towards credit expansion growth.

Housing Bubble which was the main cause of 2008 financial crisis was promoted by the U.S Fed to recover from recession in 2001 post the dot com bubble and to lift the stagnating economy which was facing stagnant wages and jobless growth.

In U.S.A housing prices were already rising at 5.2 % annually from 1995 -2000(The

Financial Crisis Inquiry Report, 2011) due to government’s announcement that home mortgage interest payment would not be taxed; it was looked as a sector for profitable returns. Since every sector in U.S economy except housing was facing a sluggish growth therefore to prevent the U.S economy from plunging into recession Fed decided to reduce it’s fed fund rate to 1.75 %,which was the lowest since 40 years , to promote the housing sector which had the potential to stabilize the economy because of the wealth effect generated due to rise in the housing prices which could further increase the consumption demand.

The low fed fund rate resulted in the fall in fixed housing mortgage rate which is for 30 years .The reduction in the house mortgage rate along with over-optimistic expectations among the economic agents about the housing sector gave an impetus to the demand for houses; consequently, resulted in rise in their prices. In few regions of America rise in the housing prices were more in comparison to other states of America that incentivized construction activities and construction jobs in California and Florida; from 2002 to 2005.Because of the expansionary effects due to the housing bubble economy stabilized in 2003, but Fed continued to decrease its policy rate to 1 % and maintained it till June 2004; gradually increased it later.

According to Case and Shiller (2003), 83 to 95 % of the house buyers were expecting the house prices to rise by an annual growth of 9% for the next 10 years. The low fed fund rate for a long period of time along with over-optimistic expectations about the housing prices accompanied by cross border flows from China along with lax regulatory regime encouraged financial innovation in search for a higher yield and one such financial innovation is C.D.O s

CDO is a financial product which is a complex form of securitization. Before the development of securitization, lender bore the entire risk of the default of loan payments by the borrowers ,and since the loan payment by the borrower was done for a few decades thereby ,the lender was careful in the screening of his borrower’s .Also, securitization used to happen in U.S by G.S.E agencies (Fannie Mae and Freddie Mac) in 1970s for prime mortgages ,but in this new product ,lenders sold their non -prime mortgages to the dominant players of Wall Street-Investment Banks ,and they combined large number of mortgages ,including car ,credit card debt and student loans, to create a complex financial product ,which is a form of derivative, called collateralized debt obligations. These CDOs were evaluated and rated by the rating agencies(who were compensated by the investment banks for evaluating these securities) ,and then these securities were sold to investors all across the world by these investment banks, and the investors of these CDOs received payments from the original borrowers. Because many of these CDOs were given the highest rating which is the AAA rating, and hence many retirement funds across the world invested in these products.(Retirement funds across the world are allowed to invest only in safe securities).

C.D.Os in the absence of any financial regulation was a recipe of disaster for the financial system because no financial agent in the financial system had skin in the game; therefore it encouraged expansion of credit volume by predatory lending.

In the U.S financial markets the number of subprime home mortgage loans increased by a large amount from 2003 to 2006. (Subprime borrowers are the borrowers with tarnished credit history , no fixed job and low paying capacity).To attract subprime borrowers banks were selling Alt A mortgages (These mortgages involved very low interest payment for initial few years followed by a rise in the interest payment after 3 years ).

The whole securitization chain with large subprime mortgage loans survived because of the optimistic expectations about the house prices. The repayment of these subprime mortgages was dependent on the rise in the price of houses (In the anatomy of every asset bubble, in the phase of Euphoria agents believe that the price of the asset would always rise) . The initial plan to insure payment from subprime mortgages was refinancing of the Alt A mortgages by the other lender after the end of low interest rate period of their Alt A mortgages because the rise in the value of their home equity due to spike in the house prices would make them eligible for a higher loan; after refinancing of their loan they would pay their original lender a penalty fee. Moreover, since banks sold these mortgages to the third party and hence had less skin in the game so they were continuing with predatory lending.

There was rise in the market share of the origination of subprime mortgage loans due to chain of securitization and over-optimistic expectations about the prices. Moreover, lack of regulation by the regulatory body further expanded lending to the subprime mortgage buyers as these subprime mortgages were combined to create CDOs and these toxic CDOs somehow managed to get AAA ratings, which indicated to their investors that they were as safe as the government securities. Though Federal Reserve could regulate the housing mortgage industry as it was authorized to do so, but Alan Greenspan, the Federal Reserve chairman chose not to impose any regulations, and this further inflated the bubble in the housing sector. Not only Federal Reserve, but Security and Exchange Commission did not conducted its role as a supervisor and regulator of the investment banks properly, despite warnings from FBI in early 2004 about the fraud in mortgages later in 2005, Raghuram Rajan, warned that a crisis could occur because of the incentive structure that encourage risk taking behavior followed by warnings from Nouriel Roubini’s , in 2006.

In 2006 though the housing prices reached its peak, but it was accompanied by rises in the delinquencies in Alt A mortgage segment dominated by subprime borrowers because the mortgage brokers denied refinancing of the Alt A mortgages since they realized that the housing prices have reached its maximum peak; the subprime borrowers were unable to pay the higher rate of interest on Alt A mortgages after the end of the low interest rate period. Further, there was rise in the unsold housing inventory; as the housing prices started to level off these manufacturers of CDOs started fuelling the market with synthetic CDOs to bet on the future of the housing market.

By the end of 2006, Goldman along with selling CDOs started purchasing credit default swaps from AIG. This financial product was sold in large number of quantities by AIG, the world’s largest insurance company. They worked just like an insurance policy wherein the buyer of these swaps paid AIG a quarterly premium and in case of CDOs going junk , AIG promised to pay the buyers of these Credit default Swaps a compensation for the losses occurred by them. On the face of it, CDOs characteristics looks like a regular insurance policy, but this financial product differs from regular insurance policy as this product could be bought from AIG even by those investors who didn’t own any CDOs ; consequently, it could lead to rise in the amount of loss for the insurer in case of unfavorable situations. Moreover, credit default swaps were not regulated .Simultaneously, Goldman was persuading its customers to buy these high quality CDOs, and at the same time they were betting against the CDOs purchased by their own customers, and if these CDOs failed Goldman would get paid by the AIG as they bought credit default swaps from A.I.G; simultaneously they had insured themselves against the potential collapse of A.I.G. Furthermore in 2007, they started selling more toxic CDOs that could help them make more money by betting against their own clients. Goldman Sachs was not alone in this fraudulent practice of selling the junk CDOs with AAA rating and then betting against them to make more profits, but Morgan Stanley, Hedge funds Tricadia and Magnetar were involved in similar practices. While they made billion of dollars, the pension funds all across the world incurred huge losses as pension funds were the institutional investors who invested in these toxic CDOs, they were completely ignorant about the fraudulent practices by Investment Banks who paid the rating agencies to get the highest rating for toxic CDOs.

The three rating agencies Fitch, S&P and Moody made billions of dollars giving high ratings to risky securities. These rating agencies were compensated by the investment banks for giving the highest –AAA ratings to the toxic CDOs created by the investment banks. The authenticity of these ratings by these top notch rating agencies could be inferred from the following examples - Before the fall of Lehman Brothers, rating agencies gave it AA rating ,and AIG was rated AA after it’s rescue by the government ;Moreover ,Fannie Mae and Freddie Mac were given the highest ratings by these agencies during there time of rescue. After the collapse of the system in 2008, when these rating agencies were testified in court, they argued that their ratings were merely their opinion; investors should not rely entirely on their opinion before making investment decisions.

Dependence on financialization to boost the stagnant monopolistic economy by U.S resulted in widening of inequality between the working class the profit earners and thereby aggravated the core problem of lack of aggregate demand .Instead of addressing the problem of slack in demand by depending on the bubble led growth which is induced by low federal fund rate government should focus more on social spending through fiscal expansion. Moreover, sometimes the debt driven speculative bubble becomes so large that it can lead an economy to severe debt deflation. Further, post the crisis government has reduced the Fed Fund rate to 0% for nearly 10 years now; this has resulted in commodity market crisis, emerging market crisis (2013) and may be the next crisis is few years away.

Change in the U.S Financial Regulation.

The push for Financial Liberalization by economist was a result of blind faith in self correcting nature of markets which were policed by self regulation. The norms proposed for both developed and developing countries under financial liberalization included removal of the interest rate ceilings which encouraged competition between various financial firms to attract depositors and lenders and thereby resulted in reduced interest margins, and led to more volume selling by financial firms to ensure their profitability .The other norms proposed included ease in the conditions for participations of both firms and investors in the stock market by breaking of the “Chinese Wall” between banking and nonbanking activities leading to increase in the universal banking that increased the financial interlink ages ,liberalization of the rules governing the kinds of issuance of the financial instruments and all these suggestions were accompanied by a shift towards voluntary adherence to statutory accounting and capital adequacy norms.

In 1980s U.S.A also witnessed changes in the regulations governing its financial industry which were adopted post Great Depression. In the earlier regulatory regime, U.S banks were permitted to do only vanilla banking while investment banks, which were small private partnership entities then, were allowed to handle bond and stock trading; there was always a Chinese wall between banking and nonbanking activities. However, under the new regulatory regime governing financial institutions in 1980s ,Investment banks were allowed to raise funds from public and this provided these investment banks with huge funds to carry out risky activities as earlier these investment banks were constrained from carrying risky and profitable activities because of the watchful partner. The passage of Germain Depository Institutions Act of 1982 deregulated savings and loan associations; allowed banks to provide adjustable rate mortgage loan. Moreover, Clinton administration allowed the passage of Gramm Leach Bliley Act, known to some as Citigroup Relief Act in 1998 which allowed the merger between Citigroup and Travelers which overturned the Glass Steagall Act that   prevented banks with consumer deposits from engaging in risky investments; led to the breakage of the Chinese wall between banking and nonbanking activities and this gave green signal to a lot of future mergers.

The deregulation carried out since 1980s by the U.S government led to the explosion of the financial industry in U.S.A. and led to concentration of too big to fail financial conglomerates. The deregulation led to various crises in the economy like the dot com bubble which was fuelled by the investment banks; the burst of the bubble caused recession in the economy in 1980s. Moreover, since deregulation began big financial institutions in U.S were involved in cases involving money laundering, defrauding customers, and major accounting scandals.

Financial Crisis in 2008 was again a regulatory failure of the federal agencies to regulate the O.T.C derivative market and the investment banks, despite having powers by the regulatory authorities. With the advent of 1990s, there were advancement in technologies and deregulation of the financial sector and push for the role of Financilization that led to bombardment of the complex financial products by the Mathematicians, which were claimed, by the bankers and economists, to be the products that made the markets safe, by hedging risks; however, they made the financial markets unstable. These financial innovations, that destabilized the financial markets, were not seen as a serious threat by the businessmen, politicians and regulators, but according to Warren Buffett they were weapons of mass destruction ;however, Congress passed the Commodity Futures Modernization Act in 2000 that banned any regulations on derivatives (weapons of mass destruction) also the passage of this   act resulted in elimination of the oversight of both the CFTC and the SEC; post the passage of this act, the use of derivatives and financial innovations rose exponentially .

The passage of S.E.C 2004 allowed five largest investment banks to leverage more; allowed them to reduce their mandatory capital requirement, which provides buffer in times of turbulence, this further led overleveraging of the balance sheets of these investment banks and thereby increased their dependence on short term money market. Moreover, due to lax regulatory regime of S.E.C these several investment banks lowered their mandated leverage ratios by selling their assets right before the reporting period, and they used to buy them later.

According to Daniel Alpert, Managing Director Westwood Capital,”The degree of leverage in the financial system became absolutely frightening; investment banks were leveraging up to the level of   33: 1, which means a slight decrease in the value of their asset base would leave them insolvent which eventually happened in 2007 and 2008 with the run in the repo market due to spread of panic due to rise in the delinquencies in subprime mortgages.

Compensation scheme in financial services industry encouraged more risk taking behavior

Raghuram Rajan in 2005 presented a paper in Jackson Hole Symposium for which he was mocked by the other economists .His paper talked about the incentive structures of the bankers that encouraged more risk taking that might be detrimental for their own firms in the long run , or the financial system itself. These bankers are rewarded for making short term profits in the form of cash bonuses, but they are not penalized for the later losses incurred due to their short term focus rather than long term. He suggests that compensation should be based on risk adjusted performance. Not only bankers but mortgage broker’s incentive structure also encouraged risky behavior as they were also rewarded for selling the most risky and profitable subprime mortgage loans.

U.S Government’s failure to rescue Lehman Brothers

By 2008,the home foreclosures were skyrocketing, and there was a breakdown in the securitization chain as lenders could no longer sell loans to the investment banks followed by the collapse of the market for CDOs, leaving the investment banks will huge amounts of loan and real estate’s which they could not sell in the markets, and they were at an increasing risk of going insolvent followed by Bear Stearns running out of cash in March ,2008,but was later acquired by JP Morgan Chase for 2 dollars a share; this deal of 30 billion dollars was backed by Federal reserve in the form of provision of emergency guarantees. On September 7, 2008, Fannie Mae and Freddie Mac were taken over by the Fed to prevent the biggest mortgage lenders from collapsing. Later on September 9,2008, Lehman Brothers stock prices fell down the cliff as they declared record high losses of 3.2 billion dollar followed by liquidity problems faced by them on September 13,2008.Lehman was not the only investment bank who was on the verge of collapsing but was accompanied by another investment bank named Merrill Lynch ;however, later it was acquired by Bank Of America. The only firm that came in the rescue of Lehman was British firm Barclay’s, the deal was almost finalized, but in the last moment British regulators intervened and demanded a financial guarantee from the U.S government, which Henry Paulson (Treasury secretary of the U.S government at that time) refused, and on September 14,2008 Lehman Brothers filed for Bankruptcy.

Paulson and Ben Bernanke by allowing the collapse of Lehman made the biggest mistake as that event triggered the Global Financial Crisis. Both of them failed to understand the foreign bankruptcy laws because under British’s bankruptcy laws Lehman’s London office had to be closed immediately. This resulted in thousands and   thousands of transactions at Lehman Brothers, London office coming to a halt; panic spread among hedge funds that discovered that they could not get their assets back. Lehman Brothers failure resulted in collapse of even commercial paper market. The collapse of commercial paper market resulted in a rise in the unemployment rate as many companies are dependent on commercial papers for meeting their payroll expenses.

Though government prevented further catastrophe of the financial system by taking over AIG on September 17 th , 2008.

Conclusion

Global Financial Crisis 2008 was a result of the dependence on financialization by the policy makers to lift the stagnating monopoly capitalist system that promoted the housing bubble, lax regulatory regime, Intellectual Support for deregulation, Incentive structure that promoted risk taking behavior. Moreover, this crisis could be avoidable .Lessons from this crisis should be learnt so that the world never sees such a devastating crisis which was the result of mistake done by humans.

References

1 The Financial Crisis Inquiry Report, 2011

2 Inside Job documentary, 2010

3 The Age of Monopoly-Finance Capital, John Bellamy Foster, Feb 1, 2010

4 Kindleberger, C. P., 1978, Manias, Panics, and Crashes: A History of Financial Crises, New York: Basic   Books, revised and enlarged, 1989, 3rd ed. 1996

5 Ghosh, Jayati. "The economic and social effects of financial liberalization: a primer for developing countries." (2005): 2006