EDITORIAL: US financial meltdown worsens ...
by Peter Westmore
News Weekly, October 11, 2008
The financial crisis that has engulfed the United States was predicted years ago.
As the US Government promised to pump $840 billion dollars into the US financial system by taking over the bad debts of home-lenders and investment banks, the crisis deepened with the nationalisation of a large British bank and the collapse of the huge Washington Mutual, following a run on the bank.
The US Federal Reserve engineered the takeover of Washington Mutual, one of the largest banks in America with 2,239 branches and a nominal asset value of nearly $400 billion. It was sold to America's largest bank, JP Morgan, for just $2 billion after Morgan agreed to take over its debt portfolio.
Washington Mutual is just the latest American bank to have closed its doors over the past year.
The problem is now far beyond the sub-prime mortgage market, which collapsed in August 2007. It has engulfed America's finance industry, and spread to international financial institutions and to the real economy in the US, Japan and Western Europe which have moved to negative economic growth.
Across the world, stock markets have carved hundreds of billions of dollars off the value of corporations.
Borrowing rules relaxed
What caused the crisis to spread from the home-loan market to the financial system? An analysis published in the New York Sun recently stated that, four years ago, the US Securities and Exchange Commission (SEC) substantially relaxed the borrowing rules for America's five top investment funds, Bear Stearns, Merrill Lynch, Lehman Brothers, Goldman Sachs and Morgan Stanley.
A former SEC director Lee Pickard told the New York Sun that, in 2004, the government regulator permitted the five investment houses to exceed the former 12:1 debt-to-capital ratio, the Net Capital Rule, which had been in place since 1975.
After 2004, the investment houses became effectively self-regulating, with the consequence that Merrill Lynch allowed its debt-to-capital ratio to spiral upwards to 40:1, and the others did the same.
According to one analyst, the firms' debts mushroomed to between $600 billion and $750 billion each.
In the emerging financial contagion in 2008, all five investment houses have either gone to the wall, or been rescued by government-funded bailouts.
The US collapse affects Australia in a number of ways. The massive decline in stocks across the world will severely impact on the retirement income of people dependent on their investment income.
Separately, the uncertainty surrounding the largest investment houses has spread throughout the financial system. The prevailing view is that if companies such as Lehman Brothers have gone to the wall, many small investment houses operating in the same environment, face the same fate.
With the extent of cross-investment in the finance industry, and the highly integrated financial markets around the world, it is inevitable that a collapse in one part of the system will inevitably affect every other part.
The extent of the integration of global financial markets can be seen in the Australian Security Exchange (ASX).
Over the past two years, ASX has negotiated with a range of stock exchanges around the world, to permit Australian investors to put money into overseas markets, including the New York Stock Exchange (April 2007), Chicago Board of Trade and Chicago Mercantile Exchange (July 2007), London Stock Exchange and Borsa Italiana (October 2007), International Security Exchange and Deutsche Borse (December 2007).
The extent of Australian investment in these exchanges will not emerge for some time.
The sudden collapse of American banks and investment houses has also caused inter-bank loans, the lubricant which keeps the financial system operating, to freeze up. The cost of borrowing has skyrocketed over recent weeks, prompting the US Federal Reserve and other central banks (including Australia's) to pump hundreds of billions of dollars into the banking system, just to keep it operating.
Whether these desperate measures work is still quite uncertain. Whether they unleash other evils, including global stagflation and a run on the US dollar, will become apparent over the next few months.
The financial collapse now evident in the US was predicted years ago by B.A. (Bob) Santamaria and others.
As far back as 1989, Mr Santamaria warned that the global economy, based not on production but on financial speculation and debt, was unsustainable.
In 1996, American economist Thomas Palley wrote an important article in the Atlantic Monthly, titled, "The forces making for an economic collapse".
He noted the soaring level of debt in the United States at the business, personal and government levels, and said, "The high level of indebtedness in the US economy implies that if prices and wages start falling, spending and fresh borrowing will most likely collapse, and bankruptcies will rocket."
He added, "The economy could then find itself in a contractionary spiral, with wage deflation feeding a collapse in spending, and collapsing spending further feeding wage deflation."
- Peter Westmore is national president of the National Civic Council.