“I hate the fact that we have to do this. But it is better than the alternative.” That is how Hank Paulson, the US treasury secretary, explained his decision to spend $700 billion on buying up “toxic” debts held by US financial institutions.
The world’s bankers, finance ministers and corporate chiefs have been gripped by panic following the collapse of Lehman Brothers, the world’s fourth largest investment bank.
Lehman’s demise brought back dreadful memories for those who run the world economy.
Some compared it to 1973, when soaring oil prices sparked a recession that ended the post-war boom, the longest in the history of capitalism.
Others went back further, to 1929 when the Wall Street Crash heralded a collapse in world trade and the Great Depression of the 1930s that was only ended by a cataclysmic world war.
Some are now confidently claiming that the crisis is over. But in truth no one knows what the outcome of current events will be.
Massive state intervention might just stave off a 1930s style collapse.
But such moves will result in huge levels of public debt at a time when the US budget deficit is tipped to rise above $1 trillion.
This deficit, combined with high interest rates and low rates of investment, could lead to an extended period of negative or low growth. A similar pattern gripped Japan through the 1990s.
Nevertheless the crisis has set off a debate that has permeated down from the boardrooms and treasury committees into everyday conversation.
Is this crisis over? Was it the result of a few rogue bankers? Is the world economy “fundamentally sound”? Could more regulation of financial markets stop this chaos? Or is this a crisis rooted in something more fundamental – the failure of the free market and capitalism itself?
That is a conclusion our rulers do not want us to reach. But as Socialist Worker shows here, it is precisely the conclusion we should draw.
What lies behind the current crisis in the banking system?
The turmoil is rooted in the so-called US “sub-prime” mortgage market, whose collapse over a year ago began the “credit crunch”.
This market developed as lenders raced to find new targets to sell their mortgages to.
They made loans available to people with low credit ratings or on low incomes at extortionate rates of interest.
This meant people took on a level of debt that was impossible to manage. The market began to unravel as it became clear that people could not afford to repay these levels of debt.
But the bad debts did not simply affect the lenders who issued the mortgages. They spread across the world financial system because of a “secondary market” in mortgage debt.
Mortgage debts were repackaged into bonds that were bought and sold by other institutions. Traders and banks speculated on the value of these bonds.
When people began to default on their mortgages last year it became clear that these bonds were far riskier an investment than many had previously believed.
But because of the way that the debts had been repackaged and sold on, no one was quite sure where the bad debts had ended up or how big they were.
Banks stopped lending to each other out of fear that they would not get their money back.
This created the “credit crunch” – when the credit between banks that had been easy to come by suddenly dried up.
Banks borrow and lend money to each other in the form of short term loans in the course of their everyday business.
Some, such as Northern Rock, relied heavily on this short term borrowing to finance their business, rather than using the traditional means of deposits in customer savings accounts.
When the lending stopped, Northern Rock was plunged into disaster. The government stepped in to nationalise it last year.
Speculation has fuelled the crisis. As investors and traders lose confidence in their bets, they moved their money elsewhere, creating panic among others who then followed suit.
Is the crisis all the fault of speculators?
As banks have crumbled, we have seen obscene cases of people making millions of pounds from the collapse of these companies.
They did this through “short selling”. Traders, often working for secretive financial groups called hedge funds, take shares “on loan” for a given period of time.
They sell them immediately in the hope the price will drop and buy them back at a later date – hopefully at a lower price so that they can pocket the difference.
Even in the gambling dens of the stock market, sharp practice is frowned upon. So the government has banned this practice, for certain stocks and for a short time.
As the revolutionary socialist Karl Marx put it, the financial system is “one of the most effective vehicles of crises and swindle”.
For instance, “insider dealing” is illegal. But knowing in advance that a company is going to announce something, knowing whether that news is good or bad, and so knowing whether to buy or sell shares, is highly lucrative.
One study of 172 mergers on the US stock exchange found that insider dealing took place in every single case.
But the crisis is not just down to the activities of a few rogue traders. It is down to the chaotic nature of the whole financial system.
The bank HBOS got into trouble last week because of its huge debts, not because of short selling. Only 3 percent of its shares traded on the day of its collapse were down to this kind of activity.
Can the central banks save the market?
The US government has agreed to take on bad debts. This will swell the nation’s budget deficit to massive proportions.
That will affect the US’s ability to further intervene on any such scale if the markets go into freefall again.
We were told US state intervention had worked when it moved to underwrite the giant “monoline” insurers at the start of this year.
The same thing happened again when it bailed out Bear Stearns in March and once more when it effectively nationalised mortgage giants Freddie Mac and Fannie Mae earlier this month.
The US, Britain and other major states have injected massive amounts of public money into the system, so that banks can borrow cheaply.
There are limits, however, to how much of this can be done. For instance, the scale of the debts in circulation is far larger than the output of the world economy.
There is no guarantee that, apart from briefly lifting share prices, anything will be achieved by this. It is simply giving free money to the stock market, which may never be returned if the crisis continues. This happened when the US government attempted the same thing after the Wall Street Crash in the 1930s – the recession continued to grow apace.
The Chinese government holds billions in US government bonds and must be very nervous about their worth. More importantly even the US government is near the limits of what it can spend.
Meanwhile there is no sign that financial institutions will start lending or investing – they want to hold onto cash. That threatens the wider economy.
In the 1990s the Japanese government spent massively to try and reverse a similar situation. The result was it was burdened with huge debt repayments which meant a decade of recession and stagnation.
There are fears that in return for holding off an immediate collapse the giant US economy is doomed to a more drawn out crisis.
The collapse of the mighty US investment banks is a further blow to Wall Street’s financial dominance.
A US that is economically wounded remains the number one military power in the world and in this situation it could be pushed to wield that more power even more readily.
Why does the state intervene to save some firms but not others?
There have been major interventions by the state in recent weeks to try and prop up institutions, such as the takeover of Fannie Mae and Freddie Mac. They were said to be “too big to fail”.
But the US failed to bail out the giant Lehman Brothers just a few days later.
The ruling class has no answer to this crisis. It is divided over the best way to respond. It is worried about what impact failing banks will have on capitalism and the system’s credibility among ordinary people.
So last week Gordon Brown arranged a deal for Lloyds TSB to take over HBOS. HBOS needed to borrow billions of pounds a day to do business and the squeeze on lending – and its increased cost – meant this became harder to do.
The government could not risk Britain’s largest savings bank failing. One in five mortgages in Britain are with HBOS and one in ten people have current accounts with it.
Whether states bail out the banks also depends on the timing. Sometimes the ruling class may believe that the system can absorb a failure without it leading to more serious damage.
States have to consider their own levels of debt – whether they can afford to bail out companies or not. And state intervention raises ideological problems – nationalising companies challenges the neoliberal ideology that has dominated the world since the 1980s.
But because recession is inherent in capitalism our rulers cannot ultimately resolve it and divisions among them means there is no consistent response.
Why does capitalism go through cycles of booms and slumps?
The chaos that we see around us is only the latest crisis of capitalism. The global economy has undergone a series of recessions over the last 35 years, including in 1973, 1990-93, 1998 and 2001-2.
Profit rates have not recovered to the level they were at before the 1973 crisis. Each time a recession ends, the prophets of the free market tell us that all of the problems in the system have been fixed. But then they are thrown into panic by the next recession.
This cycle of booms and slumps is down to the competitive and anarchic nature of capitalism. Because there is no centralised plan for the economy, each company tries to grab the biggest share of the market by producing more of one or more goods.
This leads to more goods being produced than are needed and these pile up unsold – hitting profits, forcing companies to the wall and leading to workers being laid off.
Workers then have less money to buy goods, which makes the crisis worse and the system goes into slump.
The failings of some companies then helps with the revival of the system as their competitors buy up their technology and markets.
Underlying all of this is a fundamental problem with the system – the tendency of the rate of profit to fall.
Karl Marx identified this tendency over 100 years ago. It does not mean that actual profits fall – companies are still making billions and many are increasing their profits. But the rate of return on their investments, over time, tends to decrease.
This is because real value comes from workers’ labour. The value people create through work is greater than the amount they receive back in wages.
Therefore the capitalist is stealing some of the value workers’ labour has created. This “surplus value” forms the basis of profit.
But the pressure on bosses to compete means that they try to cut the amount that they have to invest in labour.
Instead they invest in new technologies that mean they will spend less on workers. They can produce the same or more with less people because of new technology or machinery.
It also means that they will try to increase the level of exploitation of workers – making people work harder for less.
Companies may benefit from investing in new technology in the short term because they can undercut their competitors. But once the other companies catch up, this advantage is lost, and bosses must try and find new ways of increasing their profits.
The falling rate of profit pushes capitalists to try and constantly find new ways of making money.
They may do this by developing new markets or by building up speculative bubbles.
This may keep the economy afloat temporarily and mask the problems that exist. But because crisis is built into the way that capitalism works, these same problems are bound to re-emerge in the future.
What are the financial markets?
At its simplest, the financial market is a large casino. But it is essential for the running of capitalism.
Capitalism is a system based on companies competing with each other to maximise their profits. Generally they invest some of their profits in new equipment in an attempt to gain an advantage over their competitors.
But 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.
They can also provide 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.
But the financial system 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.
In modern capitalism, assets can take on a life of their own. Huge casinos develop – New York’s Wall Street or the City of London – where the rich can speculate on stocks and shares, currency prices or other investments.
Neoliberal deregulation has led to a flurry of new ways to gamble at the casino of the market.
Futures contracts, for instance, involve placing enormous bets on what the price of a commodity will be at a given time.
Futures are the simplest examples of derivatives – financial instruments whose value is “derived” from another simpler instrument. These derivatives allow traders to lay complex bets on the prices of stock and bonds without having to own them.
The theoretical value of all derivatives was $596 trillion at the end of 2007.
This spiralling of markets integrates the financial system on a global level. But it also leads to complete chaos when it all goes suddenly wrong.
One example is the effect of the market in mortgage debts that have collapsed in the last year.
Rather than holding debts and collecting interest payments companies merged them together and sold them as bonds. Others then gambled on the prices of these bonds.
Yet other institutions took out insurance on what these bonds would be worth – “credit default swaps”.
The recent bankruptcy of Lehman Brothers, the fourth biggest investment bank in the US, has triggered multi-billion dollar payments from insurers to people who held debt bonds.
But since these insurance deals are privately traded from one institution to another, no one has the slightest idea of who owes what to whom – or whether they can pay.
Will the financial crisis affect the wider economy?
The wider economy is affected by what goes on in the financial markets. 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 that they create.
The financial markets are what Karl Marx called “fictitious capital”. Their activities do not generate new wealth or expand production. They are the gambling of profits created by workers – and ultimately they depend on the health of the real economy.
However exaggerated the claimed value of shares may be, they are related to the level of dividends that the firm pays out, which in turn is connected to profits. If profits are falling the firm will not be able to pay out dividends and share prices will fall.
Markets can, for a time, soar far above the values justified by real profit rates. This creates a speculative bubble that must inevitably burst.
There are real consequences when this happens. For instance, the main investors in hedge funds are pension funds. Ordinary people’s pensions are the chips they are gambling with.
Further crisis in the financial sector feeds back into the real economy. No credit means real companies going bankrupt and not just bankers losing their jobs.
The billions of pounds given by the government to PFI companies involved in schools and hospitals are tied up in the money markets. Each bail out and investment to help the market means giving public money to the bosses that could be spent on services.
What impact will the crisis have on ordinary people?
Commentators are speculating that we are about to see a repeat of the Great Depression of the 1930s. There are some similarities with that time – the role played by speculation and credit in the crash, for example.
But the truth is that no one knows whether we are facing a dramatic 1930s style crisis or a more protracted recession.
One thing is for certain – our rulers will try to make working class people pay for the crisis, just as they did in the 1930s. We are already seeing a big rise in redundancies and unemployment, with more job losses threatened. Britain’s housing market has virtually stalled.
The crisis in the financial sector means that banks are much less willing to give credit to people and businesses. This has several consequences.
The economy has been bolstered by the availability of cheap credit. Wages have been held down but people have still been able to buy consumer goods because of credit.
Now that this is no longer available – together with a rising cost of living, wage restraint and fear of unemployment – people are spending less. This increases the economy’s problems.
Governments are pumping billions into the financial sector to try and oil the wheels of capitalism.
They also bail out companies if they think that their failure will have a negative effect on the rest of the economy.
This is leading to an increase in countries’ budget deficits.
Some £87 billion has been added to Britain’s national debt because of the nationalisation of Northern Rock. National debt now stands at 43.3 percent of Britain’s income.
At the same time, rising unemployment means less money paid in taxes. New Labour and the Tories will attempt to push through cuts in government spending to deal with the deficit, threatening services and pensions.
Private companies will attempt to cut costs by attacking the final salary pension schemes of their workers.
What can ordinary people do to resist the attacks?
The key factor in how the recession impacts on us is how working class people fight back.
This turmoil is part of a global crisis. But the government could implement a number of measures to ease the pain for ordinary people – and we should demand that it does.
Many multinationals continue to make billions while workers are suffering. The energy companies rightly became the focus of attention when they raised energy prices while making record profits.
The government could implement a windfall tax on these profits. This could then be used to give subsidies to low paid workers and those on benefits to deal with the price rises.
The government could go further and introduce a cap on energy price rises. It could nationalise the energy companies. It could raise corporation tax to increase the amount of resources at its disposal to combat the effects of any recession.
Taxing the rich and the profits of the corporations could raise billions of pounds that could then be ploughed into council house building and public services.
The government could use the money to raise benefits and pensions.
We should demand that the government scraps its public sector pay limit, which means millions of workers are seeing their pay cut in real terms while prices soar.
There will need to be grassroots resistance to all the attacks, just as there was in the 1930s.
This means people organising to stop the repossession of homes, occupying factories and other workplaces against closures to save jobs, and intensifying the revolt against below-inflation pay deals among trade unionists.
Recessions bring the instability and madness of capitalism to the fore. Millions will now be questioning the whole basis of the system.
In this situation our rulers will try and divert blame for the crisis in other directions. They will try to scapegoat immigrants and the unemployed.
As competition between capitalists and states becomes more fierce, so does the possibility of more war. This is why it is crucial that ordinary people unite and fight together – both to halt the devastation that the recession will bring and to beat back attempts to move society to the right.
Are reforms enough?
Economic crisis is part of capitalism. The only way to end recession is to replace the anarchic system with a democratically planned economy based on workers’ control – socialism.
But this will not appear out of nowhere. It has to be created by ordinary people themselves.
Many people can see that the system doesn’t work for them – most starkly at times like this.
The problem is that we grow up in a system where the dominant ideas are that capitalism is the only way to organise society.
But the system also pushes people to fight back – and in doing so working class people gain confidence. People suddenly find that they can do things they once thought impossible – whether that is organising a strike, speaking at a public meeting or arguing with other people to win them to resisting attacks.
Fighting for reforms and challenging the priorities of the system breaks down the dominant ideology.
Revolutionaries fight for reforms for two reasons. The first is that we genuinely want such reforms – we want to stop the privatisation of services, challenge racism and improve workers’ rights because these things mean important changes to ordinary people’s quality of life.
But fighting for reforms also brings people into activity, and increases their confidence and questioning of the system.
The fact that capitalism cannot provide the things we need means that many people will be radicalised and see the need to fundamentally change the world.