TAYLAN TOSUN: How did the mortgage crisis in the U.S. turn into an epic recession in the real economies of the many advanced capitalist countries?
JACK RASMUS: The mortgage crisis occurred when the subprime mortgage securities market collapsed in price. About $4 trillion was issued from around 2002-07. The mortgage crash did not cause the crisis, rather it was the precipitating event. To understand the process, it is essential to also understand the idea of securitization.
Securitization occurs when a financial asset is combined with other financial assets to create a new security, a new financial asset. So securities are bundled together and then resold, often with a markup. The bundling and repeated markups occur on top of each other. The bundles are in turn bundled, marking up each time. Assets are created, sold, recreated, and resold, piling up a financial edifice of securities and debt on top of each other—creating a pyramid of securitized debt that drives up financial asset prices to unsustainable levels that must eventually crash.
It’s important to note that financial assets are based on real assets to begin with. A house is a real asset. The mortgage is the financial asset for it. But mortgages combined together create a mortgage bond. When the bond is sold, it means money is made on the bond as well as the original mortgage. When mortgage bonds are then combined with other financial assets, like an Asset Back Security, for example, it creates what’s called a Collateralized Debt Obligation (CDO). When CDOs are combined, they create a synthetic CDO. When an insurance contract is written on top of all that, it’s called a Credit Default Swap, or CDS.
What I’ve just described is a series of derivatives, each built upon the other, each marked up in price and resold and money profits are made each time. It creates a kind of inverted financial pyramid of securities, which is still based on the original house and mortgage, a real asset. So we have both financial assets based on real assets and financial assets based on other financial assets in the pyramid. When the narrow point or base of the period declines in value—i.e. the house—then the prices of all the financial assets built on it also eventually decline. That’s what happened with the subprime mortgage crash.
The mortgages were sold to buyers who couldn’t afford the monthly mortgage payment. They could at first, because the banks sold them, knowing the buyers could not afford to pay. So why did they do that? Don’t bankers want collateral for loans? Not when they plan to resell the mortgages in 60 days to speculators who plan to bundle them with other mortgages for resale and then bundle again with other securities for further resell, etc. Bankers only wanted to create quantities of mortgage loans, not quality of loans. When mortgage interest rates began to rise in 2005-06, the buyers could no longer afford to make the payments. Mortgages started going into default by those homeowners with subprime loans. The defaults lowered the value of the real asset of the home, and, in turn, the mortgage, the mortgage bonds, the CDOs, S-CDOs, CDS that were built on the original home value. A chain reaction of asset price deflation set in.
Because many shadow and commercial banks were all in the game, lending to each other to make subprime mortgages, the crash spread to all of them. Because other forms of credit were also connected, those, too, were afflicted with financial asset price deflation. The subprime mortgage market went first and was quickly followed by other credit markets. A general credit crash set in. This is how the financial crash spread from bank to bank and financial market to financial market.
As credit dried up everywhere, the financial crash transformed into a sharp contraction of the real economy. Non-financial companies and households could not get loans from banks. Experiencing big losses, the banks would not loan except at ridiculously high interest rates. Normal businesses couldn’t or wouldn’t borrow. Without working capital loans, they had to cut costs. That meant massive layoffs. For several months, nearly a million workers a month were being laid off. Consumers stopped spending, which meant more loss of revenue for companies that needed even more loans and couldn’t get them. They had to lay off and cut even more costs. The financial crash not only propagated from subprimes to other credit forms, but also from financial credit to the general, non-financial economy. One can explain this process in terms as well of debt-deflation-default and the three price systems explained above.
The much faster and deeper collapse of financial asset prices and then in turn of the real economy resulted in an epic recession—a sharp, deep, and longer duration economic contraction precipitated by a financial crash. Normal recessions don’t have the financial crash element, although depressions do. Epic recessions are a kind of anteroom to a depression and can transform into a depression, if the defaults and deflation aren’t checked and stopped in the short run, and, in the longer run, if the excess debt created is not somehow expunged from business, bank, and household balance sheets. The government effectively expunges the debt held by the banks and big businesses, by transferring that debt to its own government and central bank balance sheets. But it doesn’t do it for households. That’s why banks and big corporations quickly recover in an epic recession, Type I, but consumer households and workers don’t. The U.S. central bank quickly offsets the losses of the banks by means of quantitative easing and six years of near zero interest rates. Trillions of business tax cuts under Obama bailed out the big non-bank companies, while workers and consumers were left to fend for themselves. There’s never been a jobs program or housing rescue program of any consequence under Obama since 2009. That’s a classic Type I epic recession scenario. In a Type II epic recession, the government and central bank don’t expunge the debt of the private banks and big businesses either fast enough, thoroughly enough, or even at all. That’s Europe today. And Japan yesterday.
Since 2009, the central banks of the United Kingdom, European Central Bank, and Bank of Japan all chose to inject trillions of dollar equivalents into their banking systems to repair their balance sheets. But a recovery has never been realized and providing lots of money to banks didn’t work out. Why?
The Bank of England followed the U.S. Central Bank lead in 2009-10 and bailed out UK banks with quantitative easing and near zero rate massive liquidity injections. The U.S. central bank had pumped dollars into the UK and Eurozone banking system that added to the liquidity. That kind of free money offset the banks’ losses on their balance sheets—in effect transferring the bank debt to the balance sheets of the central banks. Other measures were also taken to boost bank balance sheets in the U.S. and UK. Their banking sectors quickly recovered.
In contrast, the Eurozone did not have a bona fide central bank. The ECB can only do what the 17 national central banks are willing for it to do. The Eurozone has been trying to create a true banking union, but, thus far, has not been able to do so. The premier national central bank in the EZ, the Bundesbank of Germany, does not want to give up its role to an ECB. So the EZ has been doing a number of substitute liquidity injections, called the Long Term Refinancing Operation or LTRO. But LTRO is not as efficient.
It is also worth noting that because it has had no massive bank bailout, the EZ has adopted a more stringent fiscal program in the form of a more draconian austerity program, compared to both the U.S. and UK. It has had no real financial recovery and, of course, no real economic recovery. It keeps slipping in and out of recession, already having had a double dip recession and now on the way to a third dip.
Since 2009, Japan has already had a triple dip and its massive GDP contraction last quarter strongly suggests it’s headed for a fourth recession. Japan has a true central bank, but it waited even longer than the U.S. and UK to bail out its banks. It only introduced a QE liquidity bailout program in 2013. It then raised taxes on consumers, a fiscal tightening policy and its version of austerity. The Japan economy contracted this past spring.
All the AEs have introduced some form of fiscal austerity since 2009 and have introduced forms of monetary liquidity injections. But the liquidity injections used to bail out their banks will eventually come back to haunt them. It only pumps more excess liquidity into the global economy and feeds still further the speculative investment shift and enables the finance elite to grow even more and destabilizes the economy even more seriously down the road.
I’m living in an emerging market, Turkey, where after the short contraction of 2009 for us, and other emerging markets, our economies grew remarkably. How could such remarkable growth rates have been possible and to what extent were they healthy?
That’s because the massive liquidity injections by the central banks of the advanced economies—the U.S.-UK and now the Bank of Japan and soon the ECB—flowed out of those economies to a large degree to finance investment in the emerging markets (EMEs), especially China.
China’s initial response to the 2009 crash was a massive fiscal stimulus, equal to around 15 percent of its GDP, which focused on direct government investment. That was the opposite of the fiscal responses of the U.S. U-K and Europe. China recovered rapidly because China’s recovery stimulated demand for commodities and other resources and goods produced by the EMEs, China pulled up the EMEs. The EMEs were also the direct beneficiaries of the money capital inflows from the AE central banks. AE banks diverted the QE and zero rate loans to offshore markets, both into real asset investment and financial asset investment.
The combination of China’s rapid recovery due to fiscal policy and government direct investment and the U.S.-UK -Europe monetary policies together benefited the emerging market economies like Turkey, the BRICS, and others like Mexico, Indonesia, etc. Was this growth healthy? So long as the money capital flowed into these EME economies from the AEs and so long as China boomed. But now China is rapidly slowing in demand for EME commodities, resources, and imports. At the same time, the U.S. and UK are phasing out their QEs and are about to raise interest rates as well. That will reverse the money capital flows back to the AEs and slow the growth rates in the EMEs as well.
In a series of articles you wrote recently you observe that the center of the global crisis is shifting to the EMEs. Can you explain the reasons behind this shift?
Basically, now that the central banks of the U.S. and UK have fully bailed out their banking systems via QE and zero rates, they realize there is no need to continue to do so by these monetary measures. The governors of the central banks, Janet Yellen in the U.S. and Mark Carney in the UK, realized that more liquidity injections won’t deliver much more results and, more importantly, that it is beginning to create new financial asset bubbles worldwide. So they are reversing these policies.
What it means is that, as interest rates rise in the U.S.-UK in 2015, money capital will start to flow out of the EMEs and back to the AEs. The stock and bond markets in the EMEs will begin to decline. Capital will leave the EMEs for the higher returns in the U.S.-UK. In turn, less capital in the form of foreign direct investment into the EMEs will also take place. The EME currencies will then decline and have already begun to do so, seriously in some cases, as in Argentina, Chile, and elsewhere. The EMEs will attempt to stem the capital outflows and currency declines by raising their own domestic interest rates to attract capital. But that will slow their domestic economies further. Those EMEs weakest in terms of exports to the AEs and China, will be hit the hardest.
So we are entering another phase of the epic recession globally. A reversal is underway between growth differences in the AEs and the EMEs. The global finance capital elite made a big profit killing in the EMEs since 2009 with the free central bank money provided by the AEs. Now they’re taking the money out and moving on to new speculative opportunities in the AEs. The global money parade of finance elite and shadow banks are moving on to new pastures, so to speak. The AE finance capitalists largely engineered the boom in the financial and real asset markets in the EMEs and now they are engineering the contraction in the EMEs. Perceived another way, they are about to export the recession and stagnant growth in the AEs for the past six years to the EMEs. In that sense it’s not healthy. The EMEs are being manipulated by the global finance capital elite.
Why can’t the global economy arrive at a real recovery as it did many times during the post-war period? What makes things so different now?”
After six years of so-called recovery from the 2008-09 financial and real crash, the Eurozone is slipping into deflation and another recession. Its banking system is increasingly fragile. It continues along the path of fiscal austerity. It has no central bank in a real sense and no fiscal union at all. And now it has been dragged into a war in Ukraine by the U.S. that will further weaken the Eurozone economy. Unemployment remains at record levels, political instability is growing, and that will further affect its economy negatively.
The United Kingdom economy experienced a short recovery, because it returned to a policy of artificially boosting its housing markets—a repeat of the problem that led to the speculation and crash of its banks back in 2008. The UK has also benefited from foreign capital inflows. Its prime minister, David Cameron, is sucking up to the Chinese and anyone that will send money back to the UK. The UK has begun to raise its interest rates a little. That quickly began to slow its economy. The UK economy is already looking like it has peaked.
In Japan, new massive QE injections by its central bank had the typical impact of boosting stock and currency markets, but had little effect on Japan’s real economy. Wages and consumption were all falling despite QE and then, this past spring, consumption collapsed with the sales tax increase. Japan’s politicians are at a loss about what to do next. They will probably revert to still more QE, with little effect on the real economy and some effect on stocks and currency appreciation. Japan’s economy has been pretty much a spent force since the late 1990s.
Then there’s China, which is increasingly struggling with hot money in-flows from shadow banks and global finance capitalists who have been speculating with its currency until recently and causing bubbles in its local housing and local government spending markets. Every time China tries to confront the shadow bankers, its policies backfire and slow its real economy. So it backs off, adds more mini-stimulus fiscal spending and the speculators return again. This cat and mouse game has been going on since 2012, and China has been in a slow decline in its rate of growth, probably no more than 6 percent according to independent estimates, or less than half of its 2010-2011 boom period. The premier accounting firm, Standard & Poors, recently recommended that China abandon its GDP target of 7.5 percent growth. That’s a signal that China’s GDP is, in reality ,less and will slow further. China has recently also introduced its second mini stimulus package in as many years.
Emerging markets, as we noted, will in turn slow as China slows and as U.S.-UK raise rates. That leaves the U.S. economy. Because it can, and has, successfully exported part of its economic slowdown and will continue to do so. In the U.S., and, in fact, in all the AEs, real wages, and disposable income are stagnant at best, keeping consumption from a real recovery. U.S. consumer spending is heavily dependent on more consumer debt or it is driven by the big capital gains of the wealthiest 10 percent households. Every time business invests in inventories in expectation of the consumer spending big, it doesn’t happen. Inventories are reduced and the U.S. economy falls to near zero growth rates. As U.S. interest rates soon begin to rise, the economy will growth still slower.
Unlike the European and Japanese economies, the U.S. experiences repeated economic relapses whereas Europe and Japan experience bona fide double, triple, quadruple dip recessions.
In today’s newest phase of the global epic recession, Europe and Japan will not add anything to global recovery and will remain a drag on that recovery. What’s new is that China is slowing and the EMEs are about to as well. As a recent Bank of International Settlements Report has shown, the global economy has not reduced its level of debt. Debt has grown, especially in the private sector and among households. That means if another financial crisis erupts somewhere—a large bank collapsing in Europe, or in Asia, or even in Latin America—it may precipitate a more general financial crisis spreading elsewhere. That financial instability event will occur on a global economy far weaker than it was in 2008. The still excessive debt levels would set off deflation in asset prices and then goods prices more severe than occurred before.
Will central banks bail out investors and the private banking system again, after having provided around $20 trillion in the recent bailout? I don’t believe so. I believe they will have to let a bank or two go under and let, not only the bond holders and investors pay for the collapse, but also the depositors. In Europe they already announced their plan to do make the depositor pay. That could prove extremely destabilizing, should it occur. The consequences of that are unknown.
I think, as well, that central bankers may be surprised by the unexpected negative psychological effect of a relative small rise in interest rates on investment and consumption. Just as the long drop in interest rates since 2008 to near zero have had little effect on the real economic recovery (as is typical in an epic recession), so may central bankers find that, inversely, it won’t take much of an increase in rates to send the economy back into recession. To summarize, the very fragile condition of the global economy today makes the global economy increasingly susceptible to another banking crisis.
That crisis, should it occur, would almost certainly prove worse than the 2008 event and will come on a real economy that hasn’t recovered in terms of household spending. It will come on a global economy with even more total debt today than in 2008, with government deficits in many places even greater than before, and with political instability rising worldwide as well.
The weakening economies in Europe, Japan, the slow growth in the U.S. and the slowing in China today, and EMEs tomorrow, do not make for an optimistic scenario. Another financial instability event will definitely appear well before the end of the current decade.
As to your point of why the situation is different today from other recessions in the post-war period, the answer is the other recessions were not precipitated by, or related to, financial crashes. That’s because the shadow banks and finance capitalist elite, i.e. the global shift to speculative investing, was not as developed back then. Recessions were normal, caused by external shocks, and thus easily resolved by means of traditional fiscal-monetary policies. But epic recessions are financially induced recessions, internal to finance capital—endogenous as economists say—and not due to external shocks, and therefore largely indifferent to traditional fiscal-monetary solutions.
The alternative solutions to those traditional and failing fiscal-monetary policies must include the creation of quality jobs and sustainable household income growth. Reversing the shift toward more financial speculation, that is, diverting money capital from real investment must also occur. Other structural changes include the elimination of debt from household balance sheets by expunging of that debt if necessary, the breaking of the economic power of shadow banks and the new global finance capital elite, the strict prohibition against the creation of inside credit and the restructuring and democratization of central banks so they serve the entire populace not just the bankers and shadow bankers. But all that is not likely anytime soon, to say the least. It will take another financial crash and economic contraction that will follow before such alternatives are even begun to be considered.
Z
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Taylan Tosun is a member of the Party of Equality and Drmocracy in Turkey, as well as a member of the International Organization for Participatory Democracy (IOPS). See Z November for Part 1.