Ali’s blog

Mostly quant stuff with occasional digressions

Houses of cards, castles of sand

Posted by alifinmath on March 16, 2008

In the Telegraph:

You have to go back to the banking crisis of the Great Depression to find a moment when the financial system as a whole seemed so close to the precipice.

Debt levels have been much higher than in the Roaring Twenties; the new-fangled tools of structured credit are more opaque: the $415 trillion nexus of derivative contracts is untested. Nobody knows for sure if the counter-parties are able to deliver on vast IOUs, or whether the construct is built on sand.

What keeps Federal Reserve officials turning at night is fear that the “financial accelerator” will now set off a vicious downward spiral. There is a risk of “very adverse economic outcomes,” said Fed vice-chair Don Kohn.

Albert Edwards, global strategist at Societe Generale, said the toppling banks are merely a symptom of a deeper rot. “The banks are not the problem. Nor even the grotesquely leveraged funds. The problem is that an economic bubble financed by ridiculously loose monetary policy is unravelling,” he said.

And an old essay (2002) in the Monthly Review which gives a bit of theoretical context to what’s happening:

The vast expansion of the debt of U.S. corporations, including financial institutions, is clearly bound up with this widespread and growing speculative activity. Enron was simply an exaggerated example of this. The result is a financial structure that is more and more shaky, more prone to disaster if the underlying economy weakens and if new forms of financial instruments, designed to put off the day of reckoning, are not constantly introduced.

Where this will lead no one knows. At best, the pile-up of debt and the increasingly shaky nature of the debt structure place limitations on economies struggling to emerge from a cyclical downturn. At worst, a serious financial meltdown could further destabilize the capitalist world economy.

And for those who don’t shy away from theory, a more recent 2007 essay, also in Monthly Review, by John Bellamy Foster:

For the owners of capital the dilemma is what to do with the immense surpluses at their disposal in the face of a dearth of investment opportunities. Their main solution from the 1970s on was to expand their demand for financial products as a means of maintaining and expanding their money capital. On the supply side of this process, financial institutions stepped forward with a vast array of new financial instruments: futures, options, derivatives, hedge funds, etc. The result was skyrocketing financial speculation that has persisted now for decades.

When Paul Baran and Paul Sweezy wrote Monopoly Capital in the early 1960s they emphasized the way in which the state (civilian and military spending), the sales effort, a second great wave of automobilization, and other factors had buoyed the capitalist economy in the golden age of the 1960s, absorbing surplus and lifting the system out of stagnation. They also pointed to the vast amount of surplus that went into FIRE (finance, investment, and real estate), but placed relatively little emphasis on this at the time.

However, with the reemergence of economic stagnation in the 1970s Sweezy, now writing with Magdoff, focused increasingly on the growth of finance. In 1975 in “Banks: Skating on Thin Ice,” they argued that “the overextension of debt and the overreach of the banks was exactly what was needed to protect the capitalist system and its profits; to overcome, at least temporarily, its contradictions; and to support the imperialist expansion and wars of the United States.”

If in the 1970s “the old structure of the economy, consisting of a production system served by a modest financial adjunct” still remained—Sweezy observed in 1995—by the end of the 1980s this “had given way to a new structure in which a greatly expanded financial sector had achieved a high degree of independence and sat on top of the underlying production system.”14 Stagnation and enormous financial speculation emerged as symbiotic aspects of the same deep-seated, irreversible economic impasse.

This symbiosis had three crucial aspects: (1) The stagnation of the underlying economy meant that capitalists were increasingly dependent on the growth of finance to preserve and enlarge their money capital. (2) The financial superstructure of the capitalist economy could not expand entirely independently of its base in the underlying productive economy—hence the bursting of speculative bubbles was a recurrent and growing problem.15 (3) Financialization, no matter how far it extended, could never overcome stagnation within production.

The essay is a masterpiece and I recommend a printout. By the way, one book mentioned — “Monopoly Capital” — is one I’ve had with me for the last thirty years and is a seminal piece of work by two prominent American Marxist theorists.

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