[RSCT] primer on Wall Street Meltdown

[Bob Peterson]

Dear friends,
I have been struggling with how to address the financial meltdown and  
the bailout with my fifth graders. I realize that the first thing  
with any good teaching is for me to understand the issue better. It's  
been tough, but here is the best explanation that I have found thus far.

Now I just have to translate some of it so it makes sense to fifth  
graders. So far the most we've done is compare the $700 billion  
figure to the amount that has been spent on the Iraq war  
(www.costofwar.com)
as part of our study of place value and large numbers.

I am curious how other teachers are talking/teaching about this.

The primer is attached and pasted below.

Sincerely,
Bob Peterson
Rethinking Schools
www.rethinkingschools.org




WALL STREET MELTDOWN PRIMER
Walden Bello*

FOCUS ON TRADE
NUMBER 143 SEPTEMBER 2008

http://focusweb.org/focus-on-trade-number-143-september-2008.html? 
Itemid=1

Many on Wall Street and the rest of us are still digesting the  
momentous events of the last 10 days. Between one and three trillion  
dollars worth of financial assets have evaporated. Wall Street has  
been effectively nationalized. The Federal Reserve and the Treasury  
Department are making all the major strategic decisions in the  
financial sector and, with the rescue of the American International  
Group (AIG), the U.S. government now runs the world's biggest  
insurance company. At $700 billion, the biggest bailout since the  
Great Depression is being desperately cobbled together to save the  
global financial system.
The usual explanations no longer suffice. Extraordinary events demand  
extraordinary explanations. But first...

Is the worst over?
No. If anything is clear from the contradictory moves of the last  
week - allowing Lehman Brothers to collapse while taking over AIG,  
and engineering Bank of America's takeover of Merrill Lynch - there's  
no strategy to deal with the crisis, just tactical responses. It's  
like the fire department's response to a conflagration.

The $700 billion buyout of banks' bad mortgaged-backed securities is  
mainly a desperate effort to shore up confidence in the system,  
preventing the erosion of trust in the banks and other financial  
institutions and avoiding a massive bank run such as the one that  
triggered the Great Depression of 1929.

Did greed cause the collapse of global capitalism's nerve center?
Good old-fashioned greed certainly played a part. This is what Klaus  
Schwab, the organizer of the World Economic Forum, the yearly global  
elite jamboree in the Swiss Alps, meant when he said in an interview  
earlier this year: "We have to pay for the sins of the past."

Was this a case of Wall Street outsmarting itself?
Definitely. Financial speculators outsmarted themselves by creating  
more and more complex financial contracts like derivatives that would  
securitize and make money from all forms of risk - including such  
exotic futures instruments as "credit default swaps" that enable  
investors to bet on the odds that the banks' own corporate borrowers  
would not be able to pay their debts! This is the unregulated multi- 
trillion dollar trade that brought down AIG.

On December 17, 2005, when International Financing Review (IFR)  
announced its 2005 Annual Awards - one of the securities industry's  
most prestigious awards programs - it had this to say: "[Lehman  
Brothers] not only maintained its overall market presence, but also  
led the charge into the preferred space by...developing new products  
and tailoring transactions to fit borrowers' needs...Lehman Brothers  
is the most innovative in the preferred space, just doing things you  
won't see elsewhere."

No comment.

Was it lack of regulation?
Yes. Everyone acknowledges by now that Wall Street's capacity to  
innovate and turn out more and more sophisticated financial  
instruments had run far ahead of government's regulatory capability.  
This wasn't because the government was incapable of regulating but  
because the dominant neoliberal, laissez-faire attitude prevented  
government from devising effective regulatory mechanisms.

But isn't there something more that is happening?
We're seeing the intensification of one of the central crises or  
contradictions of global capitalism: the crisis of overproduction,  
also known as overaccumulation or overcapacity.
In other words, capitalism has a tendency to build up tremendous  
productive capacity that outruns the population's capacity to consume  
owing to social inequalities that limit popular purchasing power,  
thus eroding profitability.

But what does the crisis of overproduction have to do with recent  
events?
Plenty. But to understand the connections, we must go back in time to  
the so-called Golden Age of Contemporary Capitalism, the period from  
1945 to 1975.

This was a time of rapid growth both in the center economies and in  
the underdeveloped economies - one that was partly triggered by the  
massive reconstruction of Europe and East Asia after the devastation  
of World War II, and partly by the new socio-economic arrangements  
institutionalized under the new Keynesian state. Key among the latter  
were strong state controls over market activity, aggressive use of  
fiscal and monetary policy to minimize inflation and recession, and a  
regime of relatively high wages to stimulate and maintain demand.

So what went wrong?
This period of high growth came to an end in the mid-1970s, when the  
center economies were seized by stagflation, meaning the coexistence  
of low growth with high inflation, which wasn't supposed to happen  
under neoclassical economics.

Stagflation, however, was but a symptom of a deeper cause: the  
reconstruction of Germany and Japan and the rapid growth of  
industrializing economies like Brazil, Taiwan, and South Korea added  
tremendous new productive capacity and increased global competition.  
Meanwhile social inequality within countries and between countries  
globally limited the growth of purchasing power and demand, thus  
eroding profitability. The massive increase in the price of oil  
aggravated this trend in the 1970s.

How did capitalism try to solve the crisis of overproduction?
Capital tried three escape routes from the conundrum of  
overproduction: neoliberal restructuring, globalization, and  
financialization.

What was neoliberal restructuring all about?
Neoliberal restructuring took the form of Reaganism and Thatcherism  
in the North and structural adjustment in the South. The aim was to  
invigorate capital accumulation, and this was to be done by 1)  
removing state constraints on the growth, use, and flow of capital  
and wealth; and 2) redistributing income from the poor and middle  
classes to the rich on the theory that the rich would then be  
motivated to invest and reignite economic growth.

This formula redistributed income to the rich and gutted the incomes  
of the poor and middle classes. It thus restricted demand while not  
necessarily inducing the rich to invest more in production.

In fact, neoliberal restructuring, which was generalized in the North  
and South during the 1980s and 1990s, had a poor record in terms of  
growth: global growth averaged 1.1% in the 1990s and 1.4% in the  
1980s, whereas it averaged 3.5% in the 1960s and 2.4% in the 1970s,  
when state interventionist policies were dominant. Neoliberal  
restructuring couldn't shake off stagnation.

How was globalization a response to the crisis?
The second escape route global capital took to counter stagnation was  
"extensive accumulation" or globalization. This was the rapid  
integration of semi-capitalist, non-capitalist, or precapitalist  
areas into the global market economy. Rosa Luxemburg, the famous  
German revolutionary economist, saw this long ago as necessary to  
shore up the rate of profit in the metropolitan economies: by gaining  
access to cheap labor, by gaining new, albeit limited, markets, by  
gaining new sources of cheap agricultural and raw material products,  
and by bringing into being new areas for investment in  
infrastructure. Integration is accomplished via trade liberalization,  
removing barriers to the mobility of global capital and abolishing  
barriers to foreign investment.

China is, of course, the most prominent case of a non-capitalist area  
that was integrated into the global capitalist economy over the last  
25 years.

To counter their declining profits, many Fortune 500 corporations  
have moved a significant part of their operations to China to take  
advantage of the so-called "China Price" - the cost advantage of  
China's seemingly inexhaustible cheap labor. By the middle of the  
first decade of the 21st century, roughly 40-50% of the profits of  
U.S. corporations were derived from their operations and sales  
abroad, especially China.

Why didn't globalization surmount the crisis?
This escape route from stagnation has exacerbated the problem of  
overproduction because it adds to productive capacity. A tremendous  
amount of manufacturing capacity has been added in China over the  
last 25 years, and this has had a depressing effect on prices and  
profits. Not surprisingly, by around 1997, the profits of U.S.  
corporations stopped growing. According to one index, the profit rate  
of the Fortune 500 went from 7.15% in 1960-69 to 5.3% in 1980-90 to  
2.29% in 1990-99 to 1.32% in 2000-2002.

What about financialization?
Given the limited gains in countering the depressive impact of  
overproduction via neoliberal restructuring and globalization, the  
third escape route became very critical for maintaining and raising  
profitability: financialization.

In the ideal world of neoclassical economics, the financial system is  
the mechanism by which the savers or those with surplus funds are  
joined with the entrepreneurs who have need of their funds to invest  
in production. In the real world of late capitalism, with investment  
in industry and agriculture yielding low profits owing to  
overcapacity, large amounts of surplus funds are circulating and  
being invested and reinvested in the financial sector. The financial  
sector has thus turned on itself.

The result is an increased bifurcation between a hyperactive  
financial economy and a stagnant real economy. As one financial  
executive notes, "there has been an increasing disconnect between the  
real and financial economies in the last few years. The real economy  
has grown...but nothing like that of the financial economy - until it  
imploded."
What this observer doesn't tell us is that the disconnect between the  
real and the financial economy isn't accidental. The financial  
economy has exploded precisely to make up for the stagnation owing to  
overproduction of the real economy.

What were the problems with financialization as an escape route?
The problem with investing in financial sector operations is that it  
is tantamount to squeezing value out of already created value. It may  
create profit, yes, but it doesn't create new value. Only industry,  
agricultural, trade, and services create new value. Because profit is  
not based on value that is created, investment operations become very  
volatile and the prices of stocks, bonds, and other forms of  
investment can depart very radically from their real value. For  
instance, in the 1990s, prices of stock in Internet startups  
skyrocketed, driven mainly by upwardly spiraling financial valuations  
rooted in theoretical expectations of future profitability. Share  
prices crashed in 2000 and 2001 when this strategy got completely out  
of hand. Profits then depend on taking advantage of upward price  
departures from the value of commodities, then selling before reality  
enforces a "correction." Corrections are really a return to more  
realistic values. The radical rise of asset prices far beyond any  
credible value is what what fosters financial bubbles.

Why is financialization so volatile?
With profitability depending on speculative coups, it's not  
surprising that the finance sector lurches from one bubble to  
another, or from one speculative mania to another.
And because it's driven by speculative mania, finance-driven  
capitalism has experienced scores of financial crises since capital  
markets were deregulated and liberalized in the 1980s.

Prior to the current Wall Street meltdown, the most explosive of  
these were the string of emerging markets crises and the US tech  
stock bubble's implosion in 2000 and 2001. The emerging markets  
crises primarily included the Mexican financial crisis of 1994-95,  
the Asian financial crisis of 1997-1998, the Russian financial crisis  
in 1998, and the Argentine financial collapse that occurred in 2001  
and 2002, but they also rocked other countries including Brazil and  
Turkey.

One of President Bill Clinton's Treasury Secretaries, Wall Streeter  
Robert Rubin, predicted five years ago that "future financial crises  
are almost surely inevitable and could be even more severe."

How do bubbles form, grow, and burst?
Let's first use the Asian financial crisis of 1997-98, as an example.  
First, capital account and financial liberalization took place  
Thailand and other countries at the urging of the International  
Monetary Fund (IMF) and the U.S. Treasury Department. Then came the  
entry of foreign funds seeking quick and high returns, meaning they  
went to real estate and the stock market. This overinvestment made  
stock and real estate prices fall, leading to the panicked withdrawal  
of funds. In 1997, $100 billion fled the East Asian economies over  
the course of just a few weeks.

That capital flight led to an IMF bailout of foreign speculators. The  
resulting collapse of the real economy produced a recession  
throughout East Asia in 1998. Despite massive destabilization,  
international financial institutions opposed efforts to impose both  
national and global regulation of financial system on ideological  
grounds.

What about the current bubble? How did it form?
The current Wall Street collapse has its roots in the technology- 
stock bubble of the late 1990s, when the price of the stocks of  
Internet startups skyrocketed, then collapsed in 2000 and 2001,  
resulting in the loss of $7 trillion worth of assets and the  
recession of 2001-2002.

The Fed's loose money policies under Alan Greenspan encouraged the  
technology bubble. When it collapsed into a recession, Greenspan, to  
try to counter a long recession, cut the prime rate to a 45-year low  
of one percent in June 2003 and kept it there for over a year. This  
had the effect of encouraging another bubble - in real estate.

As early as 2002, progressive economists such as Dean Baker of the  
Center for Economic Policy Research were warning about the real  
estate bubble and the predictable severity of its impending collapse.  
However, as late as 2005, then-Council of Economic Adviser Chairman  
and now Federal Reserve Board Chairman Ben Bernanke attributed the  
rise in U.S. housing prices to "strong economic fundamentals" instead  
of speculative activity. Is it any wonder that he was caught  
completely off guard when the subprime mortgage crisis broke in the  
summer of 2007?

And how did it grow?
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." All  
this encouraged speculation in residential housing units. House  
prices started to rise in double-digit rates. This 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."

The subprime mortgage crisis wasn't a case of supply outrunning real  
demand. The "demand" was largely fabricated by speculative mania on  
the part of developers and financiers that wanted to make great  
profits from their access to foreign money that has flooded the  
United States in the last decade. Big-ticket mortgages were  
aggressively sold to millions who could not normally afford them by  
offering low "teaser" interest rates that would later be readjusted  
to jack up payments from the new homeowners.

But how could subprime mortgages going sour turn into such a big  
problem?
Because these assets were then "securitized" with other assets into  
complex derivative products called "collateralized debt  
obligations" (CDOs). The mortgage originators worked with different  
layers of middlemen who understated risk so as to offload them as  
quickly as possible to other banks and institutional investors. These  
institutions in turn offloaded these securities onto other banks and  
foreign financial institutions.

When the interest rates were raised on the subprime loans, adjustable  
mortgage, and other housing loans, the game was up. There are about  
six million subprime mortgages outstanding, 40% of which will likely  
go into default in the next two years, Soros estimates.

And five million more defaults from adjustable rate mortgages and  
other "flexible loans" will occur over the next several years. These  
securities, the value of which run into the trillions of dollars,  
have already been injected, like virus, into the global financial  
system.

But how could Wall Street titans collapse like a house of cards?
For Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, and Bear  
Stearns, the losses represented by these toxic securities simply  
overwhelmed their reserves and brought them down. And more are likely  
to fall once their books - since lots of these holdings are recorded  
"off the balance sheet" - are corrected to reflect their actual  
holdings.

And many others will join them as other speculative operations such  
as credit cards and different varieties of risk insurance seize up.  
The American International Group (AIG) was felled by its massive  
exposure in the unregulated area of credit default swaps, derivatives  
that make it possible for investors to bet on the possibility that  
companies will default on repaying loans. According to Soros, such  
bets on credit defaults now make up a $45 trillion market that is  
entirely unregulated. It amounts to more than five times the total of  
the U.S. government bond market. The huge size of the assets that  
could go bad if AIG collapsed made Washington change its mind and  
intervene after it let Lehman Brothers collapse.

What's going to happen now?
There will be more bankruptcies and government takeovers. Wall  
Street's collapse will deepen and prolong the U.S. recession. This  
recession will translate into an Asian recession. After all, China's  
main foreign market is the United States, and China in turn imports  
raw materials and intermediate goods that it uses for its U.S.  
exports from Japan, Korea, and Southeast Asia. Globalization has made  
"decoupling" impossible. The United States, China, and East Asia in  
general are like three prisoners bound together in a chain-gang.

In a nutshell...?
The Wall Street meltdown is not only due to greed and to the lack of  
government regulation of a hyperactive sector. This collapse stems  
ultimately from the crisis of overproduction that has plagued global  
capitalism since the mid-1970s.

The financialization of investment activity has been one of the  
escape routes from stagnation, the other two being neoliberal  
restructuring and globalization. With neoliberal restructuring and  
globalization providing limited relief, financialization became  
attractive as a mechanism to shore up profitability. But  
financialization has proven to be a dangerous road. It has led to  
speculative bubbles that produce temporary prosperity for a few but  
ultimately end up in corporate collapse and in recession in the real  
economy.

The key questions now are: How deep and long will this recession be?  
Does the U.S. economy need another speculative bubble to drag itself  
out of this recession? And if it does, where will the next bubble  
form? Some people say the military-industrial complex or the  
"disaster capitalism complex" that Naomi Klein writes about will be  
the next bubble. But that's another story.

* Walden Bello is professor of sociology at the University of the  
Philippines and senior analyst at the Bangkok-based research and  
advocacy institute Focus on the Global South. This article first  
appeared in Foreign Policy in Focus, 26 September 2008.
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