There has been panic on world financial markets in recent weeks, triggered by the fear that millions of poor Americans will default on their mortgages.
The US “subprime” market was created to sell mortgages to those with low incomes. These mortgages were then bundled together and repackaged into bonds that could be bought and sold on Wall Street – with many financial institutions borrowing heavily in order to speculate.
Markets began to tumble as it became clear that these mortgage-based “investments” were far riskier than had previously been believed.
Many of the key gamblers turned out to be banks – leading to a situation where banks were suddenly unwilling to lend money to each other. The so-called “money markets” – short-term loans between banks – dried up, threatening to bring down the whole system.
Many commentators described the ensuing chaos as a “correction” to a system that has, for over a decade, relied on the easy availability of credit.
Neoliberal ideology claims that markets are self-regulating. From this point of view, the “correction” is a good thing – it should punish those who have made reckless investments, while restoring profitability to the rest of the system.
So, an editorial in the rabidly free market Economist magazine argued that “anyone who thinks that lending has been too loose should welcome a purge”. But, it continued, “if good banks fail and money for good companies dries up, the purge will wreak huge and wasteful damage on healthy parts of the economy”.
In practice central banks and governments have ignored the logic of the market and pumped money into the banking system. In just 48 hours the world’s central banks injected some £323 billion in cheap loans to banks – a sum equivalent to a quarter of Britain’s entire annual economic output.
It is not clear how long the turmoil will last, or to what extent it will spill over into the rest of the economy. Comparisons with the 1929 Wall Street Crash and the great depression of the 1930s are unhelpful – it is perfectly possible for stock markets to crash while the “real” economy grows.
Nonetheless, the situation is a serious one. Unlike many of the financial crises of the 1990s, this one is centred on the US – the biggest economy the world has ever seen. It is also a reflection of deeper problems facing capitalism.
The reasons for the chaos are rooted in the growth of what Karl Marx, writing almost 150 years ago, called “fictitious capital”. The “real” economy is based on a division between workers and capitalists. Capitalists employ workers, paying them a wage, which is typically far less than the value they create.
Marx called the excess value created by workers and grabbed by the capitalists “surplus value”. This is the source of profit.
Capitalists are also divided among themselves and they must compete to maximise their profits. Generally they will compete by investing some of their profits in new machinery and equipment, a process Marx called the accumulation of capital.
But what happens if capitalists do not have an immediate outlet for their profits, or if they need to invest but do not have enough capital?
The banking system, the stock exchange and similar institutions can provide a means of financing investment for some capitalists, while providing an outlet for the profits of others. For example, a capitalist might save money in a bank account hoping to invest it later. The bank can then lend it to a different capitalist who wants to invest now.
The financial system is crucial to capitalism, but it is also a source of instability. If there is a sudden fall in profit rates, or a loss of faith in the market, panic can spread rapidly through the system.
As Marx put it, “banking and credit thus become the most potent means of driving capitalist production beyond its own limits – and one of the most effective vehicles of crises and swindle”.
In modern capitalism, assets can take on a life of their own. Huge capitalist casinos develop – New York’s Wall Street or London’s City – where the rich can speculate on stocks and shares, currency prices, or a host of other investments.
These activities do not generate new wealth or expand production. They represent gambling of profits already created by workers – and ultimately they depend on the health of the real economy.
But markets can, for a time, soar far above the values justified by real profit rates. This creates a speculative bubble that must inevitably burst.
For instance, during the 1990s a huge stock market bubble was created in the US. Money flooded into the country, much of it invested in high-tech “dotcom” companies that had never yielded a profit.
When the bubble collapsed from 2000 to 2001, the Federal Reserve, the US’s central bank, responded by slashing interest rates. This cheap credit fuelled a new bubble in housing.
Personal borrowing also grew until, by the start of this year, some 18 percent of US consumers’ disposable incomes were used to service debt.
The subprime scandal flowed from the housing bubble. Brokers, having sold to just about everyone who could afford a mortgage, needed to find a way to sell to those who could not afford one.
The resulting subprime mortgages were bunched together and then chopped up into parcels of debt, some riskier than others. These were then packaged together with more secure loans to create impenetrably complex financial products with names such as “collateralised debt obligations”.
Banks, hedge funds and private equity firms all rushed to gamble on what they believed were low risk investments.
It was only when large numbers of people started to default on their subprime mortgages that financial institutions realised they did not have a clue how much their investments were really worth – or how much they stood to lose.
Firms with no obvious connection to US mortgage markets were hit. The panic raised concerns about other similarly complicated investments and about the banks that had lent vast quantities of money to allow people to gamble on these investments.
Amid the resulting chaos commentators have sought to reassure us that “the fundamentals are sound” – the real economy is still profitable.
The truth is more complex. There are currently two great motors of economic growth – the US and China.
In the 1980s US corporations reorganised to meet the challenge posed by competitors such as Japan. This meant, among other things, a massive increase in the rate of exploitation of US workers, who now work a week longer each year than in the 1970s and earn less in real terms.
Increased profit rates allowed the US to attract funds from across the globe, allowing both individuals and corporations to accumulate debts, and fuelling the stock market and property bubbles. The US government has also worked up huge debts, totalling $8.5 trillion or two thirds of US annual gross domestic product.
But profit rates in the US and globally remain far lower than during the “golden age” of capitalism in the 1950s and 1960s.
Profit rates are crucial to the dynamics of the system, because, as Marx pointed out, the “self-expansion of capitalism” – getting a good return on investment – is “the goal of capitalist production”, so a fall in profit rates “appears as a threat to the capitalist production process”.
Relatively low profit rates have combined with the recurrent “business cycle” that has always plagued capitalism, and led to recessions in 1974, 1980, 1990 and 2001. They have also caused the staggering growth of speculation of all kinds, as investors seek profits without having to invest in the real economy.
Chinese growth is real, but it too faces problems. It is based on exports, crucially to the US. This provides China with massive amounts of dollars, which it then lends back to the US.
This virtuous circle is based on the continued “good health” of the US, or, more precisely, on the willingness of the US, its consumers and its companies to spend more than they actually earn.
There is also a large amount of speculation in the Chinese economy. The Shanghai stock exchange has tripled in value since 2005 and up to 50 percent of Chinese loans are non-performing as capitalists rush to invest in already flooded markets.
If the US heads into recession, as the US Federal Reserve last week hinted it might, this would have a major impact on China.
In turn, this would hit the economies of Japan and Germany, which sell machinery to China, and countries providing raw materials such as oil, tin and nickel.
None of this is inevitable, but those “running” the system have no idea what will happen next.
John Lipsky, second in charge at the International Monetary Fund, recently admitted that the chaos would “undoubtedly dampen economic growth… Whether the dampening is substantial or moderate, whether it is temporary or more extended, remains to be seen.”
The British economy is far from immune. Britain has seen an astronomical growth of finance and business services under New Labour. These sectors now make up a third of the economy and were responsible for almost half of economic growth in the past year.
One in five jobs is now in this sector, and increasingly London markets itself to the world as “one big hedge fund”. A meltdown on world markets has the potential to hit Britain very hard indeed.
If that happens, the rich will try to make ordinary working people pay for their mistakes. We need to be clear that the crisis is caused by a capitalist system run by and for the rich – and that they should be the ones who pay.