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ISR Issue 55, September–October 2007


Warning signs of a coming recession

ISR's talks to JOEL GEIER, associate editor of the ISR, about the economic shock waves that have recently rocked the U.S. and the world economy

SOME YEARS ago, the Economist called the international housing bubble the biggest bubble in world history. That bubble is now deflating, and it is having an enormous impact on the banking institutions that financed that bubble and, by extension, on the stock market. Every day, another shoe drops—another mortgage lender, hedge fund, or bank goes out of business or announces that it is in trouble. The shock waves have spread throughout the entire world system. The U.S. stock market has slid below 13,000—plunging 387 points on August 9—and European and Asian stocks have also tumbled.

Although the crisis is discussed primarily as an American subprime mortgage problem (that is, loans extended to borrowers with poor credit), the truth is that the housing bubble was international. The crisis of financial markets has begun in the United States, but it has become an international one. It has created, at least temporarily, what is known as a credit crunch; the unwillingness or inability of banks or other lending institutions to provide credit even to customers with good credit ratings, because they’re so tied up with bad loans and bad debts that they are afraid to risk anything.

As a result, in the first week of August, one of France’s largest banks, Paribas, announced that three of its hedge funds (companies that market high-risk investments to wealthy investors and are not subject to the usual federal restrictions) with exposure to the American subprime market could not find any buyers at any price for their subprime mortgage bonds. They stated that there was no market in these bonds whatsoever, at which point they announced that there would be no redemptions allowed from their hedge funds. This created an enormous credit crunch. Within hours of the announcement various banks refused to loan money to corporations and other banks because they felt that things had reached such a pitch that they could only provide credit to their subsidiaries and allies.

As a result of a failure of the credit system to allow a normal functioning of business, interest rates shot up. The European Central Bank (ECB) and the Federal Reserve (the Fed) then entered the money markets and provided an enormous amount of liquidity—cash—to the banks in order to prevent a panic.

In three days starting on August 9, the ECB provided $270 billion to the banking system. The Fed provided $66 billion dollars. This was the biggest intervention in the banking system since 9/11 and the panic that surrounded it. This time, however, the problems are deeper. What is interesting is that the European banks provided four times more to the European banking system than what the Fed did domestically. Obviously, there is a bigger problem inside the European banking system than what exists in the United States. Nobody understands quite yet what this means. As this crisis unfolds, more revelations of what is actually going on in the financial system are emerging. The European banks and hedge funds do not have a greater exposure to the American subprime market than the American banks do, so obviously there is something else involved that has still not been illuminated.

The immediate credit crunch may be over, but throughout the system a tightening of credit is going on, with interest rates rising, making it difficult for businesses and consumers to get credit. What those actions would do under normal circumstances, even outside of a crisis, is to slow down the economy; and with a slower economy, there would be less profit. Quite possibly, it would be a run-up to the next recession. This is coming in a crisis in which things could be speeded up quite a bit. We’ll come back to this.

The European and Japanese economies had slowed dramatically even before this credit crunch. But the reason why things may have started here in the U.S., is because profits dropped in this country, or did not rise the way they had in the rest of the world. The Economist lists each week’s growth statistics for forty-two countries. Of these countries, growth in the United States is lower than in any of the other forty-one. Growth in the U.S. has been slower in the last year than any other economy, and the rate of profit has grown less than elsewhere. In the first quarter of this year, the Standard and Poor’s 500 (S&P 500)—the 500 largest corporations in the U.S.—made more than 9 percent more profit than they had the preceding year, even though growth was at an annualized rate of approximately one-half of 1 percent—total stagnation. But profits still looked like they were very good.

The truth of the matter is that the S&P 500 companies got 40–50 percent of their profits from their international operations, from which they made 16.5 percent higher profits than the year before; but in their American operations they only got 2–2.5 percent higher profits. Profits in this country are not doing as well as elsewhere; there’s more of a slowdown here, so the housing market and the debt behind the housing market, went into crisis here first.

The crisis is, nevertheless, an international one. It is not just that all the markets are intertwined. The credit bubble is international in scope, and so is the housing bubble. In fact, housing prices went up more in Europe than they did in the United States over the past several years.

In addition—though this is less discussed—there has been a bubble in asset prices for various corporations, and loans made to the corporations through mergers and acquisitions, private equity buyouts, hedge funds, and so on. Bad debt has built up not only in housing, but also in highly leveraged corporate loans, and these are also going to come under pressure. Indeed, they already have in the sense that the leveraged buyout boom is coming to an end. The buyout boom was even bigger in Europe than it was in the United States, and all of these things were done through massive debt that—now that interest rates are going up—will make the burden on corporations greater. Some of them will be going bankrupt as the recession develops.

What we’re seeing is the early stages of the deflating of this credit bubble that is a prelude to the recession. How long it will take to work through the system is impossible to say, because as the crisis gets worse, you can expect that the central banks of various governments will attempt to bail out corporations and banks that are in trouble to try and prevent a total bust in the financial system. It is therefore impossible at this point to say how severe this will become. But this is the biggest financial bubble in world history coming to and end.

In addition to the liquidity and credit boom of this business cycle, a possibly even more important aspect of it has been the enormous rise of China, and the fact that the United States may have missed this boom cycle. There was growth for five years, to be sure, but that growth was based on housing, tax cuts, and war spending. Very little of it, in fact none of it, came in the form of organic growth, expanded reproduction—the creation of new factories. The accumulation of capital, the creation of new means of production, did not take place on a significant scale. If anything, there are fewer factories in this country today than there were at the start of the last recession. It is that which has put pressure on profit rates in the United States in comparison to the rest of the world; and it explains why the crisis is breaking out here in the U.S. first.

Another aspect of this change in the balance of power is that the United States has run a balance of payments deficit that has become enormous. Last year it was $800 billion. In the last five years the U.S. has borrowed $2.7 trillion from the rest of the world. Its leading bankers at this point are China and Japan. The Chinese have $1.3 trillion of foreign reserves, of which 80 percent is in U.S. dollars and securities, and the relationship is no longer one in which the United States can dictate terms to China. The Chinese are strong enough to be able to counter whatever the U.S. may do in terms of protectionist measures by threatening the Americans with selling their dollars. In the preceding couple of decades, and in particular in this last boom, China became the workshop of the world, the main manufacturing country. It is now responsible for more world growth than the United States. Twenty-five percent of all world growth last year was due to China.

Because of the shift in the economic balance of power, the U.S. has fewer options to fix its problems. It cannot, for example, unilaterally lower interest rates without a coordinated international agreement, for fear of a run on the dollar as a result of the enormous borrowing that’s gone on in the last several years. Washington’s ability to deal with crisis is more constrained than in the past.

This may be a deeper recession than the last when it unfolds. All the problems of the U.S. economy—the housing bubble, the debt crunch, and the balance of payments problem, as well as a possible dollar crisis—are going to feed the oncoming crisis creating a chain reaction that makes it much worse. One, interest rates are being raised just as adjustable-rate mortgages are being reset. Two, the banks are not willing to grant mortgages as readily as in the past, so there are fewer people who can qualify. That means fewer buyers, and more housing going on to the market. That leads to a decline in housing prices, which means more defaults on housing loans, and on into a downward spiral. This then has a ripple effect elsewhere, putting various banks into hot water, creating a slump in the construction industry, and so on. As these problems come together, it leads to a general downward spiral and toward an economic bust.

This coming period is going to have a disproportionate impact on the working class and poor. In these five years of boom, real wages have not gone up. In truth, they probably have gone down for ordinary people. When the government determines inflation, it does not take into account food prices, gas prices, and health-care prices, all of which are taking a bigger and bigger proportion of people’s disposable income. Just to maintain their standard of living, people used their houses as savings, by securing home equity loans to pay down credit card debt and free up cash to spend. For the last two years there was a negative savings rate in this country for the first time since 1933. It isn’t just that people didn’t save any money; they spent more money than what they were making, and they made up for it by taking more money through home equity loans. Many of these people had adjustable-rate mortgages, and rising rates are constricting consumption, which in turn will also contribute to the downward economic cycle.

What is significant about this period is that it reveals the United States to no longer be the economic engine that pulls the rest of the world. The U.S. is the weak link rather than the strong link in the world economy. This unfolding crisis is, moreover, a crisis of neoliberal policies; that is, of rampant deregulation and the lack of state control over financial markets. It will, therefore, not only intensify the anger and bitterness inside the working class, but it will accelerate the ideological crisis of neoliberalism; a crisis that is already clearly developing around the popular upsurge of support for a single-payer health-care system in the United States.

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