The world economy has been floating on a sea of cheap credit for much of the present decade. The sharp falls on global stock exchanges last week may have marked the moment when the financial markets realised this era is coming to an end.
Cheap credit depended, in the first place, on the actions of the central banks of the leading capitalist states. In 2000-1, faced with recession in the US and then the 11 September attacks, the US Federal Reserve Board slashed interest rates to the bone.
This helped to kick start the US economy. But it also revved up the engine of financial speculation that had increasingly driven US capitalism in the second half of the 1990s.
The speculation migrated from the stock market to housing. Low interest rates made for cheaper mortgages and boosted house prices. Homeowners could borrow on the strength of their higher property values and boost their spending.
Much of this higher spending went on cheap manufactured goods imported from China. By early this year China had foreign reserves of $1.2 trillion. Many of these dollars found their way back to the US as the Chinese state bought US government debt, helping to feed the US speculation machine.
Investment banks, hedge funds and the like squeezed profits from all this cheap credit. They developed the subprime mortgage market. This lent money to poor people with bad credit records who had to pay over the odds for their mortgages.
They also engineered a flood of leveraged buyouts – takeover bids funded by borrowing. Private equity firms and other corporate predators use these to target companies that they believe can be made more profitable through “restructuring”.
Subprime mortgages and leveraged buyouts are risky. So the speculators designed new kinds of financial instruments to spread the risk.
The most important of these are collaterised debt obligations (CDOs). These allow a lender to insure against the risk of the borrower going bust by selling on part of the debt to another investor in exchange for a share in the interest.
Central bankers have been pointing out for some time that CDOs may spread risk, but, if things go wrong, they also spread instability.
As a clever investment analyst called Henry Maxey explained in a letter to the Financial Times last week, “Subprime is interesting... for what it tells us about the new US credit creation mechanism generally – that is, that central banks and the core banking system no longer control it.”
Credit is being created on a gigantic scale by hedge funds and the like pumping money into the economy. But, Maxey went on, “if this non-bank funded liquidity dries up, due to impaired risk appetite, then there is a credit shock that has real economic implications”.
This is what is happening now. The “credit shock” started when the central banks began raising interest rates. They were worried about rising inflation. Higher economic growth has increased the demand for raw materials and food.
The Bank of England and, more hesitantly, the Federal Reserve decided to make credit more expensive in the hope of slowing the economy.
Despite the Federal Reserve’s caution, the interest rate hike was enough to cause the collapse of the subprime market last spring. The US housing market and construction industry went into recession. Ben Bernanke, chair of the Federal Reserve, insisted that this was a local difficulty that wouldn’t affect the economy as a whole.
In the past few weeks he’s been forced to eat his words. The turning point came when a Wall Street investment bank called Bear Sterns admitted that two of its hedge funds heavily involved in the subprime market were effectively worthless.
Firms are suddenly discovering that it has become much more difficult and expensive to borrow money. “Fear now rules the credit markets,” the Financial Times reported last Saturday.
No wonder then that share prices, which had been boosted by the takeover boom, have dropped.
But the important question is whether the sudden seizing up of the speculation machine will spread to the real economy and push it into recession. We may soon know the answer.