The United States prides itself on being the home of free market capitalism, governed by the rule of law. However, the rapidly developing capital market crisis demonstrates once again that, faced with a systemic crisis, rules and ideology take second place to pragmatism. A similar incident happened on 15 August 1971 when Nixon arbitrarily ditched the solemn US international pledge to honour the Bretton Woods Agreements making the dollar convertible into gold at US$35 an ounce. Cynics might say that the US lives by the Gold Rule: he who has the gold makes the rules.
Hence, the unprecedented developments in which the free market took second place to untrammelled state socialism as the national debt was effectively doubled in the blink of an eye as Fannie Mae and Freddie Mac with their $5 trillion indebtedness were nationalised, to be followed in rapid succession by the bankruptcy of Lehman Brothers and the nationalisation of the world's largest insurance company AIG at a cost of $85 billion. Merrill Lynch was forced into a shotgun marriage and the last two major investment banks were forced to convert to commercial banks to stay in business and get the support of the Federal Reserve Board. Then Washington Mutual, the fourth largest bank was closed down and Wachovia, that two weeks earlier was touted as the saviour of Merrill Lynch, was folded into Citicorp. Finally, in an effort to solve a systemic crisis, there is the unprecedented proposal to use $700 billion of taxpayer funds to buy the toxic debt of a banking system bordering on bankruptcy.
This has created an emotional political firestorm, not seen since the 1930s, since the middle and working classes feel they are being asked to bail out the banker 'fat cats' who are seen as having created the problem whilst ordinary wage earners are losing their jobs and having their houses foreclosed. Of course, the story is in reality more complicated and longer standing involving a failure of government to understand and regulate adequately a fast changing industry, but it is equally a story about failed political will, ideology, rampant greed and corruption.
The House of Representatives, all of whom face re-election in 5 weeks times spectacularly rejected the bill the first time it was presented to them on Monday 29 September, an almost unprecedented slap in the face for the failed Administration of George Bush. But after the markets tumbled 7 percent in an hour's trading in the after math of the vote it seems likely a modified version will pass the Congress shortly.
It is said that success has many fathers and failure none. It is the inverse with the present situation: failure has many fathers; in banking, regulation and policy. However, the time for recriminations is later. The task now is to contain the evolving firestorm and minimise the severe global fallout that could be very destabilising in the extreme.
At the heart of the matter is the incredible growth of debt and leverage in the financial markets since deregulation set in about 30 years ago but which went into overdrive in the past ten years. Derivatives scarcely existed 15 years ago; today they total between $600 trillion and a quadrillion- that's 1000 trillion or 10 to the power 15. By comparison the world's GDP is less than $60 trillion and the capitalisation of all the world's stock markets is less than $50 trillion.
Even worse are the opaque and unregulated $60 trillion over the counter derivatives in areas such as credit default swaps related to the US mortgage fiasco. In the prophetic words of Warren Buffett they have proven to be weapons of wealth destruction on an unprecedented scale.
Scale of the problem
The US banking system is facing a solvency problem on a scale approximately as serious relative to its economy as the Asian crisis was to the region eleven years ago or the Japanese crisis of the 1990s. But because of its position in the world, its impact on the global economy is far greater.
No one has a good handle on the numbers yet. The IMF originally estimated about $1 trillion in losses and now says that will be too low. Nouriel Roubini has estimated eventual losses of over $2 trillion and Marc Faber of the order of $5 trillion. This compares with a US GDP of $14 trillion. If that is true then the $700 billion 'bailout package' may just be a down payment on the final cost.
The US budget deficit for the year beginning October 2008 seems likely to more than double and exceed $1 trillion - maybe even reaching 10 percent of GDP - and financing this could put severe pressure on the dollar since, unlike Japan and the rest of Asia, the US has a miserable savings rate and is dependent on borrowing from abroad, primarily the Middle East and Asian central banks and sovereign wealth funds to finance its twin deficits.
The potential therefore certainly exists for the financing of these deficits to be inflationary in the medium term and cause further weakness, possibly severe, in the dollar. The diversification of international reserves that has been underway since the creation of the Euro will probably gather pace. This should also be a catalyst to encourage Asian nations to step up their efforts to coordinate their currency exchange rates.
Will the programme work?
There is no certainty that the measures as proposed will work but it is reasonable to presume there will be pragmatism in its execution and any necessary adjustments will be made along the way. The political will is probably there now and it would seem quite likely that the US government may need to take an equity position in some of these institutions until their health can be restored.
The result of this catastrophe will be a period of recession, possibly global, followed by an extended period of lower growth, accompanied by a much stronger regulatory regime for the financial sector that will have to operate with reduced leverage. Bank profits in the US and Europe will be smaller moving forward as they are forced to operate with lower levels of risk.
Global Contagion
The cancer has now spread to the European banking system and daily bailouts, mergers and partial nationalisations are becoming the order of the day. Some European banks are affected because they have bought large tranches of these toxic US products whilst others, such as the UK, Ireland and Spain are affected by weak national housing markets. The Scandinavian banks are affected by their large exposure to the weak markets in the Baltics and Eastern Europe. In addition, the European Central Bank is untested in a regional banking crisis and indeed does not have either an institutional ability or authority to act at present.
The Asian economies and their banks are better placed to withstand America's problems. Lower economic growth rates in the region are inevitable but they have the ability to increase domestic demand to make up for flagging exports. At the same time, the banks have only recently recovered from the stresses of the 1997-2002 crisis period and, as a consequence, avoided much of the stupidity that consumed Western institutions during the recent housing and derivative boom. They can also see that much of the lecturing they endured about crony capitalism was sheer hypocrisy when the shoe was on the other foot.
Other consequences of the crisis
The US budget is already under pressure at a time that demographics were about to explode it in any case. The crisis will put further extreme pressures on the budget and will probably force it to moderate its international ambitions in areas such as foreign assistance and military adventurism. The election of a new president will also have to be monitored closely, since he will be under pressure for more protectionist policies.
We must hope that the lessons of the 1930s are well enough understood and remembered. The world and the markets have some very challenging times ahead. But, as is well known, the Chinese symbol for crisis is in two parts: one symbolises danger the other opportunity. Out of this crisis will rise opportunities and some brave and liquid future Warren Buffett's will profit from the misery. Others, should be careful, not panic, invest in quality assets globally and never forget there is one asset that is no one else's liability - gold. Its day is upon us as the ultimate insurance policy.
