Finance, the victor?

Published : Jan 29, 2010 00:00 IST

Government money helped giants such as AIG (above, its office building in New York) redeem their commitments through instruments such as credit-default swaps, failing which banks and other financial firms (including allegedly Goldman Sachs) would have been driven to bankruptcy.-MARK LENNIHAN/AP/FILE Government money helped giants such as AIG (above, its office building in New York) redeem their commitments through instruments such as credit-default swaps, failing which banks and other financial firms (including allegedly Goldman Sachs) would have been driven to bankruptcy.

Government money helped giants such as AIG (above, its office building in New York) redeem their commitments through instruments such as credit-default swaps, failing which banks and other financial firms (including allegedly Goldman Sachs) would have been driven to bankruptcy.-MARK LENNIHAN/AP/FILE Government money helped giants such as AIG (above, its office building in New York) redeem their commitments through instruments such as credit-default swaps, failing which banks and other financial firms (including allegedly Goldman Sachs) would have been driven to bankruptcy.

AS 2009 drew to a close, those analysing the current capitalist conjuncture could not but admit that finance capital had won another victory. A little more than a year and three months earlier, the collapse or disappearance through merger of the major investment banks, the failure and expensive bailout of American International Group (AIG) and the threat to the solvency of major international banks, which led to their subsequent acquisition by government, seemed to signal the defeat of finance.

Prior to that, over more than two decades, financial liberalisation had helped finance capital grow in size and diversify and financial managers to manipulate markets to fatten company profits and their own salaries and bonuses. The evidence that the crisis their activities precipitated would have destroyed the edifice they had created discredited and delegitimised finance and those who managed its many arms. The backlash against finance was seen as a prelude to major reform.

Thus 2009 was expected to be the year of retribution. Some chief executives and money managers lost their jobs and others had to settle for lower earnings. Radical proposals for regulating and reining in finance were placed on the table. There was agreement that the huge incomes paid to executives in the financial sector had incentivised speculation rather than improved efficiency and contributed to economic growth. Few could deny that such speculation had resulted in instruments such as collateralised debt obligations and credit-default swaps, which were termed financial innovations but had proved to be weapons of destruction even for those in the real economy with little or no engagement with finance. It was time, most people argued, not only to limit salaries and bonuses but to go back to the drawing board and redesign financial structures markets, institutions, instruments and regulatory frameworks to ensure that the 2008 experience did not recur.

However, by the time 2009 came to an end, finance had emerged as victor, especially in the United States. Despite limited evidence that the economic downturn had bottomed out, the real economy was in a shambles with high unemployment, low consumer spending and depressed housing markets. In the U.S., gross domestic product (GDP) grew at an adjusted annual rate of 2.2 per cent in the third quarter of 2009, as compared with earlier optimistic estimates of 3.5 per cent and 2.8 per cent. The unemployment rate is at a high of 10 per cent, even though first-time claims for unemployment benefits have fallen to their lowest since July 2008. And, according to commerce department figures, new home sales dropped by 11.3 per cent in December to an adjusted annual rate of 355,000.

Despite this picture of persisting gloom, fiscal conservatives are overcome by the fear that the governments fiscal stimulus, which substantially increased the deficit in government budgets, and the level of government borrowing could result in inflation or sovereign defaults or both. In the event, even before the real economy could touch bottom, let alone recover, the clamour to exit from the stimulus has begun, threatening a double-dip recession. By year-end, the real economy crisis had probably lost some of its intensity but had definitely not gone away.

On the other hand, finance exudes a new confidence and has intensified all efforts to prevent limits being set on financial sector incomes and stall the introduction of anything but the most inconsequential restraints on financial activity.

Underlying this confidence was the return to high profitability for some firms in the financial sector. What is forgotten is that these profits were the direct result of the multiple ways in which government sought to bail out the financial sector, which included explicit and implicit guarantees for and provision of credit against non-performing and near worthless assets, purchase of equity to ensure solvency in the context of write-downs of assets, and disbursement of extremely cheap credit for investment in government bonds that offered higher returns.

Government money also helped giants like AIG redeem their commitments through instruments such as credit-default swaps, failing which banks and other financial firms (including allegedly Goldman Sachs) would have been driven to bankruptcy.

Soon, the banks, especially investment banks such as Goldman Sachs, went back to their old ways and decided to use the cheap money offered by central banks and governments to speculate in stock, commodity and property markets, wherever they appeared profitable. The fact that corporate profits and equity prices were at an all-time low and could only improve, that commodity prices had also experienced a downturn after the boom of two years earlier and that some emerging economies were much less affected by the recession and had active even if not buoyant stock and property markets, made the investment of cheap money in these destinations an attractive option. In the event, the rush of capital to these markets fuelled a boom that delivered better-than-expected profits.

Consider the following. By end 2009, the stock market in the U.S. had rebounded 61 per cent relative to its March low, delivering profits for early investors and leaving the Dow Jones Industrial Average just 9 per cent below its level a decade earlier a remarkable performance for a year that saw the worst crisis since the Second World War.

But this pales when compared with the performance of the emerging markets, which have kept the boom of the 2000s going. According to Financial Times (January 1, 2010): Russias Micex index rose 802 per cent over the decade after a boom in commodities spurred its oil and metals industries. Brazils Bovespa, again driven by the commodity boom, climbed 301 per cent. Indias Sensex jumped 249 per cent. And property prices in emerging markets are rising once again. Combine this with the fact that the tail end of this boom was driven by investments financed with cheap credit, and the profits made from this bout of speculation are easily explained. In fact there are three consequences that this revival of debt-financed speculation has had. The first is the return to profitability in segments of the financial sector that are not dependent on lending to real economy players for their returns.

The second is the ability of these profit-making firms to buy back equity from the state so as to rid themselves of government control and interference. The government, in turn, could justify these sales by arguing that equity prices, now driven up by the return to profit, were such that they were making a profit.

The third is the return of the cockiness that characterised finance before the crisis. Nothing captured this new, misplaced confidence more than the statement of Lloyd Blankfein, who dismissed criticism on the functioning of finance saying he is just a banker doing Gods work.

The fallout of that confidence is that analysts are estimating that out of the profits made by Wall Street firms in 2009, as much as $200 billion would be paid out as bonuses with $23 billion of that going to employees of Goldman Sachs. What is forgotten is that much of these profits are, in the words of insider George Soros, hidden gifts from the state and, therefore, from the tax payer, who in relative terms earns a pittance. Also forgotten is the fact that the recession in the real economy, triggered by the meltdown that finance was responsible for, has not gone away.

With the year expected to be one of retribution but turned into one that left finance victorious behind us, the question as to why all this happened needs to be faced. It could not have, if governments that manage taxpayers money were not persuaded that if finance was not saved capitalism was perhaps doomed. In the U.S. (and elsewhere) this task was not too difficult since revolving doors connected Wall Street and the government and neoliberalism, which favours finance, dominated the economics profession. The direct and indirect links between Wall Street and the U.S. Treasury are now too well known to need emphasising.

But the sources of influence of finance on policy-making went beyond mere cronyism in the decision-making apparatus.

To start with, the sheer size of finance and the integration between markets and institutions meant that if some of the bigger institutions were allowed to fail, the financial system was likely to collapse. That could not be permitted, because the damage to the real economy and the ordinary citizen would have been immense. Moreover, in the age of finance, the state had used the financial system to engineer reasonable or even creditable growth in the real economy. It injected liquidity into the system through an easy money policy in order to sustain a regime with low interest rates and burgeoning credit.

With no restrictions on the provision of credit, the loans went to finance housing investment and consumption on the one hand and speculation in stock and real estate markets on the other. The asset-price inflation that such speculation generated magnified the value of the wealth held by households, encouraging them to borrow and spend even further. The outcome was growth with low unemployment, which for a variety of reasons was not accompanied by inflation in the prices of goods.

But to keep this process going, credit went to those who borrowed beyond what their incomes would warrant and on terms they could not afford, making asset-price inflation the unstable anchor to which the system was tethered. The system was soon awash with risky assets. When that gave, the edifice collapsed.

The financial sector, thus, served as an intermediary in the strategy of growth that has characterised capitalism in the recent past, in which growth appeared to be consumption and private-sector led, but in fact was engineered by the state using its monetary policy instruments. Finance enjoyed its nexus with the state because it not only made profits but was allowed to innovate financial instruments which it thought was transferring risk out of its ambit on to those sitting on the buy-side. But blinded by the thirst for profit, financial players ended up being entangled in complex ways with one another, exposing them all to the risky assets the system was proliferating.

Seen in this light, the desire of governments to bail out finance at immense cost reflects an implicit desire to return to the strategy that sustained growth for the last decade and a half, though with occasional reversals such as the dotcom bust. Just fear of the financial system seizing up cannot explain the largesse that has been offered to finance. Not surprisingly, the pay-out to finance has often been included in the figures measuring the fiscal stimulus to combat the recession. Unfortunately, neither the expenditures to bail out finance nor the residual fiscal stimulus has managed to reverse the decline that the real economy and its workers have seen. Even if the downturn has touched bottom, there are no clear signs of a return to growth and near full employment.

Finance, on the other hand, is back in business and some sections of it are doing extremely well. Its success stems from the fact that there is no alternative post-crisis strategy of growth that a restructured capitalism has fashioned. It has, therefore, emerged as victor at the end of a year reserved for retribution, even though it has lost its ability to facilitate growth and is behaving in ways that will precipitate another crisis.

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