Global financial crisis Need of a paradigm shift

The neo-liberal notion of businesses untouched by government is now without takers.

Though late, a coordinated effort is underway to overcome the world financial crisis. Starting from the US bailout plan to buy out banks with bad mortgaged-backed securities, there is a simultaneous attempt to overcome credit crunch that endanger not only banks but also big companies. There is a desperate attempt at shoring up confidence among people, to prevent the erosion of trust in banks and other financial institutions and to avoid a massive bank run such as the one that triggered the Great Depression of 1929.

Indeed, after US bailout plans, British PM came forward with much more comprehensive package in which deposit guarantee, bank recapitalisation and new debt guarantee are major components. Most of the capitalist countries are now following suit. These packages are aimed at preventing recession in real economy. Now the notion of businesses untouched by government is without takers. Developed countries, including the US, have laid down a strategy of goverment buying equity shares of banks to prevent them from collapsing.

Iceland in order to prevent bankruptcy of the economy has already announced the nationalisation of two big banks. The ramification of siphoning of taxpayer money to rescue financial institutions is yet to be seen. Nonetheless, share prices have rebounded somewhat in both the US and Europe. This has had positive effect on Asian share market too. But it is still hard to say if the crisis is over.

But how did the present crisis originate? Failure of new Keynesianism to tackle stagflation in the late 1970s brought neo-liberalism in the orbit of economic policy regime. Trade liberalisation and open policies, followed by globalisation and huge investment in the financial sector, became the vogue. But in the process, capitalist economies over-produced capital and under-consumed goods and services. The quest for high profit was met through global capital injected into the financial sector. With investment in industry and agriculture yielding low profits, large amounts of surplus funds were circulated and invested and reinvested in financial sector. The result was an increased bifurcation between a hyperactive financial economy and a stagnant real economy.

Deliberate attempts to create financial oligarchy and policy bias in favour of neo-liberalism preventing state action amidst weak regulatory system fuelled financial crisis in the US. More specifically, the policy induced speculative bubbles. The Fed’s loose monetary policy in the 1990s encouraged the technology bubble. When it collapsed into a recession, prime interest rate was cut to a 45-year low of one per cent in June 2003 and kept there for over a year. This had the effect of encouraging another bubble — in real estate. According to investor and philanthropist George Soros: “Mortgage institutions encouraged mortgage holders to refinance their mortgages and withdraw their excess equity. They lowered their lending standards and introduced new products, such as adjustable mortgages (ARMs), ‘interest-only’ mortgages, and promotional teaser rates.”

These served to reinforce speculation, and the rise in house prices made the owners feel rich; the result was a consumption boom that has sustained the economy in recent years. Big-ticket mortgages were aggressively sold to millions by offering low “teaser” interest rates.

There are about six million sub-prime mortgages outstanding, 40% of which will likely go into default in the next two years. And five million more defaults from adjustable rate mortgages and other “flexible loans” will occur over the next few years. These securities, the value of which runs into trillions of dollars, have already been injected, like virus, into the global financial system. According to Soros, credit default swaps make up a $45 trillion market that is entirely unregulated. This has shocked everyone with erosion of confidence among the people in general and investors in particular.

Thus, the Wall Street meltdown stemmed from the crisis of overproduction of capital through unfair means, leading to worsening of crisis in global capitalism. The financialisation of investment so far used as a better way to cope with stagnation as well as an attractive mechanism to shore up profitability has broken down. It produced temporary prosperity for a few but ended up in corporate collapse and recession.

Market failures are dangerous. There is a need of a paradigm shift beginning with redefinition of the role of the market and the state including the whole gamut of policies inducing free flow of capital. This has exposed multilateral institutions too most notably IMF whose prime role is surveillance of world economy. As a corollary, this has necessitated expediting a process of creating a new global financial architecture with fair representation of developing countries which have increasingly become vulnerable to advanced capitalist economies.

Dr Khanal is an economist