Northern Rock(ed)

The crisis at Northern Rock should come as no surprise, to anyone that has been reading my blogs and comments over the last couple of years. It is part of the slow motion train wreck I have been saying was almost inevitable as a result of the huge accumulation of debt promoted, and forced upon western economies, in particular the US and UK. That policy of credit fuelled expansion, and the bail out of Northern Rock – likely to be only the first of a series of bail-outs some much bigger than this one – exposes the myth of neo-liberalism that it was about free markets and non-intervention – a myth also bought even by some on the left see Dave Broder’s comment here as part of a wider discussion, and my subsequent response. The reality is, as I said in my response there, the capitalist state has been intervening on unprecedented levels over the last 20 years, and without it, western capitalism would have undergone a severe crisis, perhaps worse than the 1930’s.

What is the background? Marx was one of the first to analyse the fact that capitalism moves in cycles. He identified some of the causes of these cycles linked to investment, and credit for instance. This work on cycles is linked to, but not identical to his analysis of capitalist crises. Later economists such as Schumpeter borrowed much from Marx’s work to analyse cycles further. Schumpeter also borrowed from the work of the Russian economist and statistician Kondratiev, who in the 1920’s used Marx’s method (though Kondratiev was not a Marxist) to develop an analysis of long waves of development lasting between 40 and 60 years peak to peak.

I have given a detailed account of Kondratiev’s work, and the Long Wave theory here. There is little dispute that these long waves can be statistically identified. There is dispute over the causes. Using Kondratiev’s analysis, the end of the downward cycle which began between 1914-20, which tied in with the revolutionary upsurge at the turn of the conjuncture, and the subsequent defeats during the downturn through the 1920’s and 30’s, the new upturn should have begun around 1945, but is usually seen to have started in 1949, and, as predicted, lasted until the late 60’s early 1970’s. Indeed the crisis beginning in 1974 and detailed in Mandel’s book “The Second Slump” can be identified as a classic example of this turn and conjuncture.

Capitalist states throughout the world responded with Keynesian demand management policies, pumping liquidity into the system, which not only stoked inflation, but also failed to work, leading instead to stagflation. Faced with this crisis, capitalism did what it always does in such situations – it placed the weight of the crisis on to the working class. In Britain, Thatcher, and, in the US, Reagan turned up the heat in the class war. In Britain, unemployment in the 80’s, soared to levels higher, in absolute terms, than during the 1930’s, and unemployment, in the US, soared too. In Britain, Thatcher paid for the higher unemployment by squandering the riches of North Sea oil, in order to destroy union power, and drive down wages, in order to push up the rate of profit. In the US, Reagan achieved a similar victory, by using the position of the Dollar as the world’s reserve currency, in order to force other countries to shoulder some of the costs. Although the new Fed Chairman Paul Volcker slashed money supply, and raised interest rates to historically high levels, the Dollar tumbled against the Mark.

But having secured the necessary victories over organised labour, both Britain and the US, seeing mounting social chaos, and witnessing problems for their own capitalist class, began to turn their attention to stabilisation of the system. Another factor played into the scheme. In the late 80’s, Stalinism was losing its grip throughout those areas in which it once had political influence, in Asia in particular. Capital, in search of new investment opportunities, was looking for even cheaper labour to exploit, and these new economies opened up to it, in what we now call globalisation. If anyone had a theory, which closely reflected the process unfolding at the time, it was the view expressed, at the beginning of the century, by Karl Kautsky in his theory of super-imperialism.

Capitalism was presented with new opportunities, but serious threats. In this new world, capital flowed to these emerging economies, which grew rapidly, but, in so doing, it put even greater pressure on the old manufacturing industries in the West. A process known at the time as de-industrialisation. But, in the late 80’s, and throughout the 90’s, the West, and the UK and US in particular, responded by hugely increasing the service sector of the economy, both in the public and private sector. This had a number of consequences. Firstly, many of the jobs created in the sector were low paid, low status jobs – though a relatively few such as those in the Financial Services sector were not, on the contrary they were highly lucrative. Secondly, although some of these new jobs produced services, which were exported, many did not. This was important. Services that were exported produced earnings, which paid for the growing volume of imported manufactures, those which were not exported could only be bought effectively by credit.

What then emerged was a huge shell game. The US and UK, in particular - other European capitalist states have not been so guilty, and have persisted with higher levels of unemployment and lower growth for longer - simply began to print money i.e. to increase credit which was used to pay for imports. At the same time, the easy credit resulting from this monetary policy encouraged consumers to spend more of their money, and save less of it. In the US, savings rates have been negative for some time, i.e. people spend more than they earn. That was part of the intention, because without the demand this created, unemployment would have soared. In the 1970’s this policy had led to inflation, and stagflation. But, in the late 80’s and nineties, it did not. Inflation, as Marx pointed out, is not the result of an increase in costs. Higher wages, or even higher oil prices, do not cause inflation. Inflation is caused by an increase in the value of money put into circulation greater than the increase in the value of commodities put into circulation. Inflation arises when the capitalist state increases the money supply in this way as a means of defrauding the working class, of covering its increased costs at the workers expense.

But, in the late 80’s, and during the 90’s, the volume of commodities thrown into circulation rose astronomically as a result of the economic revolution in Asia. Moreover, although credit expanded in the West, in China and other Asian countries huge surpluses of savings mounted up, balancing out the excess spending in the West. Capitalism, however, is a system which functions by means of the continual resolution of contradictions. The US is the clearest example. On the one hand, US workers having suffered through de-industrialisation, and their living standards and ability to fight, undermined by Reagan’s class war offensive, saw real wages fall from the 1980’s until today. US workers today work on average two weeks more, per year, than they did 30 years ago, mostly in overtime. In order to maintain their standard of living, they used up any savings they had, and made up the rest with borrowing. This was facilitated and encouraged, from the late 80’s onwards, by increasingly low real, and then nominal rates of interest. With consumer prices kept low through the importation of increasing volumes of cheap Chinese manufactures, the incipient inflation that the increase in money supply should have created, found its way into other areas of the economy, primarily into asset classes such as, first, the Stock Market, creating the Stock Market bubble of the late 90’s, and subsequently, after it burst, into property.

But, as the property market began to bubble up, the consequence was to provide consumers with an asset against which they could borrow even more money. Lenders, seeing increasing numbers of people wanting to get in on this apparently never ending upward cycle, wanted to lend to anyone that wanted to borrow. Indeed those who were least able to pay back any borrowings were the most profitable, because they could be fleeced for higher interest rates on their subprime loans, and if they failed to pay, their now higher priced home could simply be repossessed. The only problem such lenders faced was how, with less and less savings by US citizens, were they to raise the necessary funds to be able to lend out the increasing amounts of money? The answer, in the deregulated financial markets instituted during the 90’s, was simple. They bundled loans to thousands of borrowers up into packages, which could then be sold to a variety of other financial institutions such as Hedge Funds. The Hedge Funds then sold these packages via their own Funds to investors all over the world, investors, which included other banks, financial institutions and pension funds. But these institutions also bundled their own loans up similarly, and sold them on to other institutions. Literally trillions of dollars in loans then circulated around the world’s financial markets, in ways which even the bankers and central bankers themselves admitted they did not fully understand. But this meant a problem. If you buy units in a Unit Trust, you can, to some degree, assess whether the fund is value or not, by assessing the value of the companies into which the Unit Trust invests. But how can you assess the value of a fund, when you do not know the value of the assets in which that fund is invested? Ultimately, the value of these funds was determined, not on any rational basis, but purely on the basis of supply and demand for the Fund, and on the assessment of the credit rating of the institution selling the Fund by the various Credit Rating agencies such as Standard and Poor’s and Moody's. 

But, two years ago, the writing was on the wall that this house of cards was going to tumble. The US had been increasing its indebtedness to other countries by increasing amounts. The indebtedness was reaching a stage that was at a tipping point. A stage where the debt interest repayments would become so large that the US would have to devote a large part of its exports just to meeting them – the position many Third World countries have faced in the past. But, another change had occurred too. The downward leg of the Kondratiev Long Wave had ended around the end of the 90’s. Its turn, announced by the debt blow-off of the Asian and Rouble crises, the beginning of the upward leg announced by the rise in the price of gold, and subsequently, as economic growth, around the world, began to escalate, of all primary products, and in China, and other Asian economies, by growing labour militancy, and increasing real wages.

Now, continued credit expansion in the US threatened to pass straight through into inflation, and the signs of that began to emerge in US Consumer and Producer Price data. The Federal Reserve, seeing demand for labour in the US also begin to increase, and capacity constraints start to emerge, began raising interests rates by a quarter of a percentage point each meeting for 18 meetings.

The consequence ultimately was inevitable. There is a saying amongst speculators that a bubble can only last as long as there is some bigger fool waiting to buy. Eventually, a point is reached when there is no fool left willing to buy an asset at the highest price. From that point on, things unwind quickly. Prices of houses in the US began to fall. Those that had borrowed money they had little prospect of repaying, now, as borrowers in Britain had experienced a decade earlier, found that their house was worth less than the money they had borrowed. The premise of the lenders that they could always get their money back by repossession, was now invalid, and the value, therefore, of all the funds that had been sold to investors and financial institutions, around the world, also now had to be valued according to the value of the underlying assets. The problem was that nobody had any idea what that value was!

The result was that all these financial institutions, banks, building societies, insurance companies and pension funds, now had assets, in the form of commercial paper, which could not be valued. As the creditworthiness of all these institutions is based upon these assets, no one knew whether any of these institutions was viable or not, whether it could pay all of its bills, if it needed to sell all its assets, or a large part of them. This meant that no financial institution was prepared to lend to another, not knowing whether it might get its money back or not. This short term borrowing is what makes financial markets operate. The London Interbank Overnight Rate, or LIBOR as its known, went through the roof, raising real interest rates for all financial institutions, raising their costs, and ultimately the cost for all their borrowers. Effectively, credit became frozen, as everyone wanted real hard cash and hoarded what cash they had themselves – in many ways, it's rather like the banking crisis of 1847 described by Marx in Volume III of Capital, which led to an economic crisis too. The difference is that that crisis was caused by the bad practice of the Bank of England, which was constrained by the Bank Act of 1844, which had been introduced on the basis of Ricardo’s Theory of Money, which, as Marx explained, misunderstood the nature of gold as money as opposed to commodity. That too coincided with the conjuncture of the end of a Kondratieff down-leg around 1843, and the beginning of a new 25 year upswing.

It is within this context that the crisis at Northern Rock has to be understood. It adopted the same kind of practices that its US counterparts used, though apparently not in terms of lending to subprime borrowers. It was dependent not on attracting savers – in fact, have you noticed that nearly all Building Societies have lots of information about borrowing, but very little about saving – but on borrowing on financial markets. When those markets froze, and the rates at which other institutions were prepared to lend rocketed, Northern Rock’s business model crumpled. The idea that this can be a short term problem is facile. A credit crunch of this nature is likely to take up to two years to resolve, and, given the unprecedented level of lending that has occurred over the last decade or so, the severity of it is likely to outweigh previous examples. It is rare, during such crises, for at least one major financial institution not to go to the wall.

But predictions of this crisis leading to an economic crisis, let alone a crisis similar to the Great Depression are unlikely. The world economy is well into a long wave expansion. The US may experience a severe slow down, even a recession, but the world economy is likely to continue its expansion for at least another 18-20 years, driven by developments in Asia, as well as Eastern Europe, much of Western Europe excluding the UK, and Latin America.

The greatest irony is that the resolution of the current financial crisis is likely to be brought about not by capitalism but by Stalinism. The Stalinists in China and Russia are sitting on huge reserves, in China as a result of exports of manufactured goods, in Russia exports of oil and gas. Neither will want to see an economic crisis in the West cause problems for their own economies resulting from a reduction in trade and exports. The Chinese Stalinists, like their Russian counterparts, having developed the economy by resort to the market, and foreign capital are increasingly drawing control back into the hands of the state more closely, and using the state to buy controlling stakes even in the private companies that have driven the economy forward in recent years. The Chinese Stalinists have created a huge fund, for the sole purpose of intervening in capital markets through the buying up of shares, and commercial paper. Nearly 20 years after capitalism thought it had buried Stalinism, it is likely to be rescued from its current plight by that very same Stalinism.

See Also:

Prepare to Dust Off the Sliding-Scale

Gold - Why Its Price is Soaring