The
Predicted Financial Storm
Has Arrived
By Gabriel Kolko
01 September, 2007
Zmag
Contradictions now wrack the
world's financial system, and a growing consensus exists between those
who endorse it and those who argue the status quo is both crisis-prone
as well as immoral. If we are to believe the institutions and personalities
who have been in the forefront of the defense of capitalism, we are
on the verge of a serious crisis-if not now, then in the near future.
The International Monetary
Fund (IMF), the Bank for International Settlements, the British Financial
Services Authority, the Financial Times, and innumerable mainstream
commentators were increasingly worried and publicly warned against many
of the financial innovations that have now imploded. Warren Buffett,
whom Forbes ranks the second richest man in the world, last year called
credit derivatives-only one of the many new banking inventions-"financial
weapons of mass destruction." Very conservative institutions and
people predicted the upheaval in global finances we are today experiencing.
The IMF has taken the lead
in criticizing the new international financial structure, and over the
past three years it has published numerous detailed reasons why it has
become so dangerous to the world's economic stability. Events have confirmed
its prognostication that complexity and lack of transparency, the obscurity
of risks and universal uncertainty, especially regarding collateralized
debt and loan obligations, will cause a flight to security that will
dry up much of the liquidity of banking. "…Financial innovation
itself," as a Financial Times columnist put it, "is the problem".
The ultra-creative system is seizing up because no one understands where
risks are located or how it works. It began to do so this summer and
fixing it is not very likely.
It is impossible to measure
the extent of the losses. The final results of this deluge have yet
to be calculated. Even many of the players who have stakes in the countless
arcane investment instruments are utterly ignorant. The sums are enormous.
Only a few of the many measures
give us a rough estimate:
The present crisis began-it
has scarcely ended there--with subprime mortgage loans in the U.S.,
which were valued at over $1.3 trillion at the beginning of 2007 but
are, for practical purposes, worth far, far less today. We can ignore
the impact of this crisis on U.S. housing prices, but some projections
are of a 10 percent decline-another trillion or so. Indirectly, of course,
the mortgage crisis has also brought many millions of people into the
larger financial world and they will get badly hurt.
What the subprime market
did was unleash a far greater maelstrom involving banks in Germany,
France, Asia, and throughout the world, calling into question much of
the world financial system as it has developed over the past decade.
Investment banks hold about
$300 billion in private equity debts they planned to place-mainly in
leveraged buy-outs. They will be forced to sell them at discounts or
keep them on their balance sheets-either way they will lose.
The near-failure of the German
Sachsen LB bank, which had to be saved from bankruptcy with 17.3 billion
euros in credit, revealed that European banks hold over half-trillion
dollars in so-called asset backed commercial paper, much of it in the
U. S. and subprime mortgages. A failure in America caused Europe too
to face a crisis. The problem is scarcely isolated.
The leading victim of this
upheaval are the hedge funds. What are hedge funds? There are about
10,000 and, all told, they do everything. Some hedge funds, however,
provided companies with capital and successfully competed with commercial
banks because they took much greater risks. A substantial proportion
is simple gamblers; some even bet on the weather--hunches. Many look
to their computers and mathematics for models to guide their investments,
and these have lost the most money, but funds based on other strategies
also lost during August. The spectacular Long-term Capital Management
1998 failure was also due to its reliance on ingenious mathematical
propositions, yet no one learned any lessons from it, proving that appeals
to reason as well as experience fall on deaf ears if there is money
to be made.
Some gained during the August
crisis but more lost, and in the aggregate the hedge funds lost a great
deal-their allure of rapid riches gone. There have been some spectacular
bankruptcies and bailouts, including some of the biggest investment
firms. Investors who got cold feet found that withdrawing money from
hedge funds was nigh on impossible. The real worth of their holdings
is hotly contested, and valuations vary wildly. In reality, there is
no way to appraise them realistically-they all depend largely on what
people want to believe and will take, or the market.
We are at an end of an era,
living through the worst financial panic in many decades. Now begins
global financial instability. It is impossible to speculate how long
today's turmoil will last-but there now exists an uncertainty and lack
of confidence that has been unparalleled since the 1930s-and this ignorance
and fear is itself a crucial factor. The moment of reckoning for bankers
and bosses has arrived. What is very clear is that losses are massive
and the entire developed world is now experiencing the worst economic
crisis since 1945, one in which troubles in one nation compound those
in others.
All central banks are wracked
by dilemmas. They have neither the resources nor the knowledge, including
legal powers, to remedy the present maelstrom. Although there is clamor
from financiers and assorted operators to bail them out, the Federal
Reserve must also weigh the consequences of its moves, above all for
inflation. Then there is the question of "moral hazards."
Is the Federal Reserve's responsibility to save financial adventurers
from their own follies? Throughout August the American and European
central banks plunged about a half-trillion dollars into the banking
system in an attempt to unfreeze blocked credit and loans that followed
the subprime crisis-an event which triggered a "flight to safety"
which greatly reduced banks' willingness to loan. In effect, the Federal
Reserve relied on banks to restore confidence in the financial system,
subsidizing their efforts.
Central banks' efforts succeeded
only very partially but, in the aggregate, they failed: banks and investors
now seek security rather than risk, and they will sit on their money.
The Federal Reserve privately acknowledges its inability to cope with
an inordinately complex financial structure. European central bankers
are in exactly the same dilemma: they simply don't know what to do.
But this scarcely touches
the real problem, which is structural and impinges wholly on the way
the world financial structure has evolved over the past two decades.
As in the past, there is a critical split in the banking and finance
world and each has political leverage along with clashing interests.
More important, central banks were not designed to cope with today's
realities and have neither the legal powers nor knowledge to control
them.
In this context, central
banks will have increasing problems and the solutions they propose,
as in the past, will be utterly inadequate, not because their intentions
are wrong but because it is impossible to regulate such a vast, complex
economy-even less today than in the past because there is no international
mechanism to do so. Internationalization of finance has meant less regulation
than ever, and regulation was scarcely very effective even at the national
level.
Not only leftists are naïve
but so too are those conservatives who think they can speak truth to
power and change the course of events. Greed's only bounds are what
makes money. Existing international institutions-of which the IMF is
the most important--or well-intentioned advice will not change this
reality.
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