The global financial crisis that is now unfolding was both predictable and predicted. It might have happened before the subprime mortgage meltdown in the United States triggered it, but it is important to stress that it was expected. “An accident waiting to happen,” as Alan Greenspan, former chairman of the Federal Reserve, put it. And now it is taking banks, investment houses, hedge funds, and speculators with it-some are just losing huge sums of money, others are going bankrupt or are up for sale cheaply. Where and how this crisis ends is utterly unpredictable, but it is already very serious.
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, one of the richest men 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. “â€¦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 increasingly unlikely.
No one can measure the extent of the losses because there is no agreement whatsoever over the value of these numerous innovations. Most of the players who have stakes in the countless arcane investment instruments are utterly ignorant. But the sums are enormous.
Only a few of the many financial debacles 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 two trillion or so. Indirectly, of course, the mortgage crisis has also brought many millions of people throughout the U. S. and increasingly in Europe into a larger, more complex financial world. Many will get badly hurt.
What the subprime market did was unleash a far greater maelstrom involving banks in England, Germany, France, Asia, and throughout the world, calling into question much of the global financial system as it has developed over the past decade.
Investment banks hold about half-trillion dollars in private equity debts they planned to place-mainly in leveraged buy-outs. They are now 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. Northern Rock in Britain, which in mid-September saw depositors withdraw two billion pounds in a few days and force it into virtual bankruptcy, is but another of many examples. A failure in America caused Europe too to face a crisis. The problem is scarcely isolated.
The leading victim of this upheaval is 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. In the opinion of many informed observers, especially the Financial Times,’ the entire financial system and the way it operates will have to be reconstructed-radically-and that is unlikely to occur. 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. 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? Their dilemma is that if they do not attempt to save these politically powerful speculators the entire financial system may capsize, and so they have increasingly been forced to attempt to bail them out-thereby making it possible for them to survive and endanger the entire system in the future.
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.
The global financial system is now out of control. Greed is rampant. Existing international institutions cannot change this reality. We are on the verge of a serious crisis-if not now, then in the near future.