Five myths about the Wall Street crisis
Beneath the startling headlines, many of the explanations for the troubles at Lehman Brothers and AIG are sub-prime.
On 24 September, in central London, spiked is hosting a public debate titled ‘Are we talking ourselves into a recession?’ Here, Daniel Ben-Ami argues that some hoary old myths about the state of the economy are being regurgitated to explain recent events. Buy your tickets for the spiked debate below.
During the troubles on Wall Street over the past few days, many pundits have parroted tired slogans as the accepted wisdom. They seem to have forgotten that their blithe explanations have been found wanting in the past and are likely to be inadequate in the present.
Hardly anyone seems to remember that back in 1998, towards the end of the Asian financial crisis, there was a similar feeling of impending doom. Bill Clinton, then America’s president, said America was facing its biggest financial challenge in half a century. George Soros, a multi-billionaire financier and vocal critic of capitalism, said the global capitalist system was ‘coming apart at the seams’ (1).
Today the situation is not the same as in 1998. Back then, the crisis started in East Asian markets before moving to the developed financial markets of the West. But many of the explanations given for the crisis were similar. And, like then, it is unlikely that the current crisis will lead to anything resembling the Great Depression of the 1930s. It is much more likely that there will be a period of sluggish growth accompanied by a steady squeeze on personal consumption. The financial markets may be highly volatile, but that does not necessarily translate into violent fluctuations in the real economy.
There are several myths about the current financial crisis that should be dispelled.
Myth one: recent developments prove that Wall Street is nothing but a giant casino.
This notion was stated explicitly by John McCain, the Republican candidate in the American presidential race, when he argued that the American worker has ‘been betrayed by a casino on Wall Street’ (2). He was, probably unknowingly, echoing the ideas of Susan Strange, a leftist thinker, who in 1986 had an influential book published entitled Casino Capitalism (3).
In fact, as I argued in my book Cowardly Capitalism (Wiley 2001), the contemporary financial markets are characterised by risk aversion rather than a hunger for big bets. This is much more than saying the markets are simply fearful. Rather, I argue that the character of the financial markets has changed fundamentally.
The main reason for their existence used to be to move capital from one party to another. For instance, someone might put their savings into a bank account and the money would then be lent to a company for investment. Today, in contrast, a key purpose of many financial instruments is to transfer risk from one party to another. For instance, the derivatives markets essentially provide a way for institutions to pass on risks between each other. So, one party might want to protect itself against a falling dollar and another might want to bet on the American currency rising.
This ‘cowardly’ nature of the financial markets explains why the financial crisis has spread in the way that it has. Repackaging or ‘securitising’ mortgages initially provided a way for lenders to sell on the risk to other parties such as investment banks. In the short term, this had what was seen as the desirable effect of diversifying risk. But the risk was simply transferred rather than disappearing. Once problems emerged it could spread more easily from one institution to another. This explains what is sometimes misleadingly referred to as a ‘contagion’ effect or virus in the market.
Myth two: the markets were driven by greed.
It would be more accurate to say that the developments are driven by fear rather than greed. However, it is not fear in the sense it is often used by financial commentators. Rather than a timeless human emotion, it is a general climate of anxiety in contemporary society that affects the financial markets as everyone else. Markets tend to react in a disproportionate way to the threats that they face.
Myth three: it is all about confidence.
It is true that confidence plays more of a role in the financial markets than in the economy as a whole. But it is a mistake to exaggerate the importance of confidence in the resolution of the crisis. The strength of the underlying real economy is a key factor to consider when trying to determine the likely outcome. The contemporary economy in the developed world has a weak growth dynamic, but it is not facing any fundamental crisis. It is characterised by sluggish growth, but there are no signs of collapse. Britain is more vulnerable than any other large developed economy because of its heavy dependence on the financial sector in general and the City of London in particular.
Myth four: it all started with irresponsible American subprime mortgage lending
The crisis is routinely blamed on irresponsible lenders and reckless borrowers whose debts have now gone bad. According to this caricature, a combination of greedy bankers and feckless ‘trailer trash’ are responsible for the crisis. In reality, the American housing bubble was simply a response to the low interest rates maintained by the Federal Reserve earlier this decade (4). This loose monetary policy was in turn a way of keeping an otherwise sluggish economy going by promoting a consumer boom fulled by cheap borrowing. The fundamental problem was therefore a weak economy rather than subprime borrowers or lenders.
Myth five: The recent actions of the American authorities, particularly last week’s nationalisation of the Fannie Mae and Freddie Mac mortgage guarantee agencies, represent an end to the free market on Wall Street
In fact, despite its reputation as the ultimate free market, Wall Street has long been subject to extensive state intervention.
Several conservative commentators have bemoaned the fact that the American authorities have taken a strongly interventionist stance on dealing with the financial crisis. For example, Charles Dumas, a director of Lombard Street Research who has previously worked for Britain’s Conservative Party, wrote in the UK Telegraph: ‘It seems that President Bush and the Republicans are not just well to the left of Grover Norquist. They leave clear blue water on the left of Gordon Brown, much to the envy of Euro-lefties no doubt, who would love to ditch what they call “neo-liberalism”, and what we call free markets, as easily as the American right wing.’ (5)
However, state intervention on Wall Street has long been pervasive. The American authorities intervene in the economy in numerous different ways and tightly regulate the financial markets. For example, in recent months the Fed has bailed out Bear Stearns (another investment bank), pumped in up to $200billion (£112 billion) to nationalise Fannie and Freddie and strong-armed top financial institutions to provide funds to stabilise the market in the wake of Lehman’s collapse. It has injected large sums into the financial markets when they have become troubled and not hesitated to move interest rates either. Indeed, as argued above, the roots of the current crisis can partly be attributed to the earlier actions of the Fed.
Daniel Ben-Ami is a journalist based in London, and the author of Cowardly Capitalism: The Myth of the Global Financial Casino, published by Wiley. (Buy this book from Amazon (UK)). Visit Daniel’s website here.
Buy your tickets now for the spiked debate ‘Are we talking ourselves into a recession?’ in London on 24 September. Click here.
Rob Lyons put the crisis on Wall Street down to risk aversion. Mick Hume also argued that risk-aversion rather than reckless neo-liberalism lies behind the current financial crisis. Daniel Ben-Ami described how even free marketeers have lost faith in capitalism. Sean Collins explained how discussion of recession is based on the economics of fear. Or read more at spiked issue Economy.
(1) Quoted in Daniel Ben-Ami, Cowardly Capitalism, 2001, p9.
(2) McCain defends comments on economy, blasts Wall Street “greed”, AFP, 16 September 2008
(3) Susan Strange, Casino Capitalism, 1986.
(4) Historical figures for the federal funds rate – the main interest rate set by the Fed
(5) Wall Street privatises US government: be very afraid, Telegraph, 14 September 2008
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