Friday, September 26, 2008

Will conservative ideology let Wall Street destroy capitalism?

Published: Friday September 26, 2008

Un-American financial socialism! Confused and ill-advised! So claim Congressional representatives on both sides. Blogs, talk shows, many a forum refer to Wall Street operatives as 'a bunch of felons'.

Commentators, ironically describing a Republican government as socialist, are corrected as wrong: these developments aren't the socialism conservatives accuse Europe of practicing, this is 'organised crime'! Some commentary and cartoonist impressions are extreme and can't appear in a family newspaper. The situation changes hourly. Currently, as I write, FBI investigates potential fraud at 26 companies including, Fannie Mae, Freddie Mac, Lehman Brothers and AIG.

We knew this would be the fallout. Conservative philosophy denounces ideologically the practice of government regulation. Further, it sees bail-out intervention as wrong. The market must self-correct as part of capitalism's creative destruction. Yet, today President Bush supports a bail-out.

Republican presidential candidate John McCain supports government intervention in campaign speeches, attacking greed on Wall Street. Obama supports it too, with caveats. What's new? Politics gets inextricably intertwined with economics once financial sector crash and rehabilitation turn up. We have our own FINSAC debates to guide us - what's new indeed? A bundle.

The economic, or rather the intensity of financial integration of the world is new. Seek evidence of globalisation: find it in world financial markets. This isn't two billion dollars in a country of population 2.5 million as in Jamaica.

Credit Default Swaps

This is trillions of dollars, global exchange and trade system, pensions scattered across the world, insurance contracts covering pianists' fingers, coastal holiday homes and more, including the now infamous credit default swaps.

Innovative and risky new financial instruments, once hailed as remarkably elegant, now defined as toxic, once created and marketed worldwide, take on a life of their own. The US budget deficit, according to Congressional Budget Office analysts, is $486 billion. This does not include ad hoc commitments for Bear Stearns, Fannie Mae and Freddie Mac of $240 billion. Top this up with $85 billion for AIG and $700 billion for a comprehensive programme a la Resolution Trust Corporation for an unprecedented commitment of taxpayer funds and the yet unborn.

The blame game will continue and intensify. Yet the process is not new. Financial crises and their resolution evolve like this. Innovation and lax regulatory oversight, for whatever reason, are followed by ad hoc responses, which fail to contain the crisis. Comprehensive solution follows with appropriate recrimination, significant policy and legislative regulatory changes - the classic process.

The problem, however, is that this situation represents conditions underlying both the way the world economy now works and the way the international monetary system evolved haphazardly, to facilitate it. The US dollar is the world's currency despite the emergence of the euro and Britain's insistence on maintaining sterling in its effort to provide some independence for domestic economic policy and the place of the city of London as a major financial centre.

Despite phenomenal growth rates China chalks up annually, despite the emergence of Brazil, India and other less spectacular 'emerging economies', the USA remains the world economy's demand driver. Indeed, without American investment and consumption, these economies couldn't achieve current growth rates.

Toxic financial products

America's housing stock was the underlying source of demand through what are now dubbed toxic financial products. If rising house values allow American consumers to experience a wealth effect, converted through mortgage loans to consumption spending, a chain reaction follows.

Construction demand grows; so does the entire co-operating legal, financial and institutional infrastructure - mortgage brokers, real estate agents, legal offices, title companies and so on. Demand for 'white goods', microwave ovens, washing machines, lighting fixtures - all paraphernalia for the construction sector experiences an explosion and the economy grows.

China, India, Brazil and others in the globalised economy step up production as US trade deficit expands. As Wal-Mart squeezes margins, US companies relocate production facilities. These countries buy US Treasuries and securities of Fannie Mae and Freddie Mac with their growing surpluses. Wall Street investment banks fund mortgage debt creating 'toxic' securities that global investors purchase. The circular flow is thus maintained. Investors seek insurance against risk, purchasing credit default swaps that AIG provides. Everyone is happy. That is, until the underlying assets turn sour.

The world monetary system experiences turbulence. If major holders of debt instruments, the investment stream allowing this circular flow to continue, begin to lose confidence the system clogs up, approaching meltdown. This is why the US government must intervene.

If the US dollar is the world's currency, the US Federal Reserve system is its central banker. Cede authority to an unsupervised Wall Street and the much discussed 'greed' will cause collapse.

This is why the unprecedented $700 billion dollar bailout is being referred to as equivalent to the Patriot Act, the authority to make war in Iraq and organised crime. Secretary Paulson is, after all, formerly of Goldman Sachs, a potential beneficiary of the bailout.

Power grab

He wants a blank cheque with no oversight. Some see Paulson as making a power grab from an unpopular lame-duck President who must stay out of the public square. While Lou Dobbs calls the plan idiotic, its Liberal critics insist the bail-out should not simply hug up toxic assets no private entity would buy off Wall Street's books without potential taxpayer benefit. The bail-out must buy a stake in the business. Politically, the bailout as currently proposed - no possibility of judicial review, no relief for small banks, credit unions, homeowners - may prove more difficult to achieve than bi-partisan authority to make war in Iraq. This is why world financial markets continue to be spooked.

Source: Jamaica Gleaner

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