What caused the financial crash?

Almost every government of the major economies are urging their citizens to accept welfare cuts, job losses, pay freezes, and bundles of what are called austerity measures because of the recent catastrophic financial collapse. In all the publicity given to the cuts, and even the invitation to citizens to suggest ways of reducing state spending, little attention is given to the causes of the crisis.

If we understand what caused it, our attitude to the austerity measures might be a little different.

The run-up to the crash

Until the mid-70s real wages in the US kept pace with increases in productivity. As workers produced more, they were paid more in real terms and their standard of living rose. They could buy more goods, consume more and that led to increases in profits for industry and economic growth.

But these companies were in competition with each other, trying to get more profit for their shareholders. In the cut-throat world of competition, either companies grow or they risk being taken over, or going bust. So they were under constant pressure to increase profits.

They could increase their market share by reducing prices but could only do that if they also reduced costs. They could expand abroad but that wasn't an option because prices overseas were cheaper. Or they could increase productivity even further but that would risk a glut in the market and falling prices.

They opted, with politician support, to hold down real wages and let productivity continue to rise. Put bluntly, workers had to work harder but didn't get a commensurate increase in pay. Their rights were reduced and working conditions became worse as productivity was pushed up. And as expected, profits continued to rise.

But the problem was that now workers couldn't afford to buy the goods being produced and there was no increase in overseas markets. So there was a crisis of over-production. Even if some companies would go to the wall, that still wouldn't solve the problem of a shortfall in demand. Some other solution had to be found.

The first "innovation"

Then someone had a bright idea, they "innovated". If workers could be loaned the money, they could buy the goods they couldn't afford with just their wages. The companies were happy because their surplus would sell. The banks were happy because they would get the interest. And the workers were happy because they could live the American dream and have it all now.

But loans have to be secured, right? It was the equity in homes that provided the security. Mortgages and second mortgages proliferated, as did credit cards. Everyone and their friend got in on the act and even car manufacturers like General Motors were making more money from lending to customers than from producing and selling cars.

But the problem with this line of credit is that it only lasts as long as the equity. The more you borrow, the less equity you can use to borrow more. And the more you borrow, the more you have to pay back because you are also paying interest on the loan. It's a recipe for families getting into unsustainable debt, risking the loss of their homes but the finance companies kept up the advertising pressure.

As the debt levels rose, there was a faint breeze of worry amongst the banks. Their lending activity had increased dramatically. In the past, banks had loaned about three times their deposits, the so-called leverage ratio, on the understanding that not everyone would remove their cash at the same time. But now the leverage ratio was around thirty to one. Banks were getting nervous and their shareholders were getting twitchy.

The second "innovation"

The banks needed some way of spreading the risk and someone came up with another "innovation". They bundled up the mortgage debt and created products which they could sell. They would sell derivatives based on the buyer getting a share of every mortgage payment. People buying these derivative products would be taking on the risk instead of the banks, but they would only do so if they thought they were safe investments.

To start with there was some interest in buying these derivatives but the banks needed to greatly increase the sales to cope with the level of risk they were exposed to. They needed to distribute the risks to keep their own shareholders happy, but how could they convince people that bundled mortgage debt products, so-called Collateralised Debt Obligations (CDOs) were worth buying?

The third "innovation"

Someone or something has to rate these products highly to encourage others to buy them. So tame companies were set up to do the ratings, and they were encouraged to rate them highly so that the banks would keep coming back to them. As the companies rated the products highly, the banks were more able to sell them, and so they used the rating companies again. This mutual back-scratching forced up the ratings to absurd levels, on a par with government securities. These inflated valuations pushed sales up dramatically and the banks were very pleased with themselves.

Foreign investors could get high returns on a product that was rated to be very safe. It was a sure bet and sales rocketed. Between 1997 and 2007 sales of these derivatives rocketed from $41 trillion to $677 trillion.

The crunch

The housing equity was more and more committed in mortgages that working people found harder and harder to pay. Their real wages were held down and they were increasingly burdened by interest payments on loans raised on their equity. It couldn't last.

As the first wave of foreclosures took place, banks became scared. First Lehman Brothers went bust, then Freddie Mac (Federal Home Mortgage Corporation) and Fannie Mae (Federal Home Mortgage Corporation) were rescued by government cash. The banks, after shivering from the initial draught, now broke out into total panic and stopped lending to each other.

With no mortgages available, the housing market collapsed, prices fell, and with it the value of the equity used to secure the CDOs. The risky loans now looked as though they were actually unsecured and panic spread throughout the markets. Those foreign investors including governments and foreign banks, found their investments dropping dramatically in value and so were the value of company shares. There was a mad rush to dump these "toxic assets". You will recall the phrase used in connection with the sub-prime mortgages.

Government reaction

The old neo-conservative argument used to be that the market would sort out the best result all on its own. Supply would always meet demand, and governments should keep out of the way. Some companies would go bust, and the better ones would survive. This belief in the market motivated a great deal of government economic policy. Unfortunately it didn't seem to work. Market competition does not maximise social benefit, it often treats social benefit as irrelevant. Profit is the focus.

The innovations which seemed so creative when they were proposed, actually generalised the crisis throughout the capitalist system reaching foreign countries and financial institutions around the world. Some countries had stayed out of the fray, such as Australia, but others were heavily committed in the speculation, such as Iceland.

Would the neo-conservatives seriously argue for the bankruptcy of entire states to allow the crisis to play itself out? What sounded like a natural law of the market was in fact the consequence of a system of capitalist competition for accumulation and profits. And it was one thing for politicians supporting business interests to argue for letting some companies go bust in a recession, it was quite another to risk the entire global financial system in pursuit of profits.

Suddenly all the neo-conservative politicians turned 180 degrees and started urging greater state involvement, rescue packages, massive loans to keep the financial companies afloat. Nationalisation of the banks, something inconceivable just ten years ago, was on the agenda of all the major economies.

People who had urged neoliberal economics for years, suddenly discovered an essential need for state spending, for government backing, for greater involvement of the state in regulation. They couldn't rely on cooperation amongst capitalists - they were driven by competition. After years of denying the state's economic role, they were now falling over themselves to declare their personal epiphanies.

Governments around the world were offering staggering sums of money to bail out the banks and other lending institutions, compensating the shareholders at a level far in excess of their true value and promising to hand them back the companies in due course.

The bankers couldn't believe their luck. Not only was the risk transferred to governments, but they were being compensated for their trouble as well. Already, as the sheer scale of the crisis was becoming apparent, Wall Street in 2008 paid it's financial executives bonuses of, wait for it, $32 billion. The rescue package that the US government put together to bail out AIG, the insurance giant, was $182.3 billion.

Picking up the tab

Of course, governments maintain their national budgets, manage borrowing, and set their money supply and inflation targets. They spend on social welfare and the provision of essential services which private corporations either can't or won't provide.

Having to obtain such massive sums at short notice to bail out the financial system is an enormous strain on national state budgets. The money has to be borrowed and then paid back at interest. And of course, those involved in the lending want assurances that they can be paid back.

That's why the IMF and World Bank are insisting on austerity measures. They want the cash back and it has to come from cuts in state spending. And that means reductions in welfare programmes and social provision, redundancies, pay cuts, and all the rest.

To pay for the financial crisis caused by speculation in the chase for higher profits, ordinary people will pay dearly. The neo-conservatives will use the opportunity to push their agenda for smaller government, selling off the state assets, and in the current climate, private companies will pick up valuable assets at knock-down prices and will then be able to sell services back to the state at a high profit.

The right response?

A global financial system based on the driven search for higher profit necessarily creates the kind of madness we have seen over the last three years. The spreadsheet has no morals, and every separate capitalist enterprise will try to maximise its own gains or face takeover or go bust. There's no choice here, just blind, mad, crazy, competitive capitalism.

The consequences in a world where corporations are bigger than states and where financial systems are integrated across the planet, are devastating. Regulation is not a sufficient answer because historically as soon as any regulatory controls are introduced, the capitalist companies "innovate" to evade them. The answer has to lie in control, direct and total control in the hands of working people who are not motivated by the drive for profit.

All of the social democratic politicians are united in defending the capitalist system which has wreaked so much havoc and they are all reluctant to contemplate any alternative. But that is precisely what responsible people should now be doing.

Given the massive global harm caused by the financial crash, including the millions of working class families who have lost their homes, the proper response is not to compensate the people who caused it, pat them on their back and fill their pockets with money, but to take their assets off them so they no longer have the power to do the same again. They have committed massive international economic damage, they are economic vandals on a global scale and they should be held to account.

We should all be thinking about how a rational society would manage its international finance. Should it be driven by the crazy competitive pressure to maximise profit at all costs, or should it be geared to meeting social need? Should private capital be able to buy the water supply of Bolivia, or should essential services be protected from the greed of the market? Should working people be forced to pay for the austerity measures designed to protect the wealthy against the consequences of their actions, or should working people actually be in control, real control?

These are important and pertinent questions which we should be asking each other.