The credit crisis rumbles on. Just when it seemed safe to sound the all clear, a wave of additional losses has toppled the heads of two major US investment banks. And it has signalled a major intensification of the global credit squeeze that threatens recessions on both sides of the Atlantic.
Few will shed a tear for Stanley O’Neal or Chuck Prince, the former heads of Merrill Lynch and Citigroup. They walked away from their posts with a combined payoff of $203 million – payment for creating losses that have so far reached $23 billion.
And they are not alone. The investment banks Morgan Stanley, Wachovia and UBS have confessed to combined losses of $8.2 billion. Others will surely follow.
The US Federal Reserve belatedly started cutting interest rates in September, more than two years after the housing market started to turn down. That was far too late. A persistent decline in house prices had long since pushed defaults among homeowners up to record levels.
Credit bubbles have notoriously long lags. Homeowners become extraordinarily optimistic during a prolonged boom, hoodwinked into believing that runaway house prices are a one way bet to riches.
Expectations are often retrospective. It takes time for the harsh reality to dawn – in the long run, property manias can never compensate for a squeeze on wages.
And “Middle America” has been buffetted by globalisation, which has led to a drop in the median (average) real wage over the past six years.
The French president Nicolas Sarkozy railed against the excesses of financial capitalism when he addressed the US Congress last week. But it is the downward pressure on wages for ordinary workers that compels governments to drive economic growth at any cost, shackling the masses with excessive and unpayable debts.
Now the bubble has burst and the average consumer is being forced to retrench. The economy has been kept afloat by the well-off, who have been less exposed to the crisis in subprime mortgages.
But last week’s monthly report from US retailers shows that even the upmarket stores are now being hit.
None of this is being helped by the surge in oil prices. In today’s globalised economy, US workers are unable to offset higher petrol prices by increased wage demands. Real incomes fall further, squeezing the economy even harder.
The West failed to plan for the inevitable “peak” in oil production by developing alternative sources of energy. That now threatens to complicate the fallout from the global credit crisis.
It will hit the British economy hard next year too. The US is an important trading partner for Britain, accounting for 14.6 percent of this country’s exports. Britain’s manufacturing remains in deep trouble. Latest figures already suggest that it will make no contribution to growth in the fourth quarter of this year, and a loss of exports to the US will hardly help.
But Britain’s reliance on investment banks constitutes a far bigger risk. Prior to the August credit crunch, the finance sector directly accounted for nearly a third of GDP growth.
That does not take into account the many “second round effects”. Employees in the finance sector saw their average incomes rise more than double the rest of the country in 2006. They climbed nearly three times as fast as public sector wages.
And the losses at the investment banks look set to multiply. Prices for the toxic mortgage bonds that lie at the heart of the current financial crisis have continued to slide over the past week.
Critically, the recent losses unveiled by the banks will not include these more damaging price declines. It is possible to follow the unravelling of this huge debt pyramid by logging on to websites which provide daily updates on these bonds.
It shows that the value of top rated “AAA” bonds are tumbling. This is no longer merely a subprime crisis. Many of these bonds are now worth only
70 cents in the dollar. The lowest rated bonds are now valued at less than 20 cents in the dollar.
We have entered the classic vicious circle, with enforced selling of bonds triggering even bigger losses and further fuelling the dumping of bank assets.
The comments from one senior executive at Morgan Stanley last week were instructive. He complained that these declines were unprecedented, and that no computer model would have predicted them. Having created the biggest credit pyramid in history, the major banks are flying blind, unable to control or manage the fallout.
We can expect to see many more job losses in the City and Canary Wharf in the coming months. But ultimately, the heaviest price will be paid by ordinary workers. And the government’s finances will certainly suffer – forcing an even bigger clampdown on public sector pay.
Graham Turner is an independent economist and a member of Respect