There are many financial examples of unrestrained capitalism wreaking havoc with nations and with the world. The most recent was the 2008 crisis that developed in the US. But there have been many more - most of which have also developed in the US because that is the home of unregulated capitalism. The 1930s Great Depression was entirely made in the USA, with almost the same characteristics as in 2008 except that it began with the stock market instead of housing.
The US has engaged in a special kind of Economic Vandalism with some frequency in recent history. In each case, excessive liquidity, fuelled by easy credit, and one kind of asset bubble or another, were the foundation for economic disaster that freely spread throughout the world.
During the 1920s, Europe was still in fragile condition, improving, but still suffering from the dramatic fall in production and other effects of the First World War. Most European economies were financially unstable because of the war debts they'd accumulated. Britain suffered less than some, but had lost 40% of her foreign assets by paying for the war. With her previously strong trading position permanently weakened, this left her more dependent upon exports and more vulnerable to any downturn in world markets.
By comparison, the US economy in the 1920s was doing very well. Fueled by easy money (provided through credit rather than savings) these years produced a US spending spree. The 1920's saw new discoveries and inventions in nearly every field, and new business and production methods created many profitable manufacturers.
Increased incomes, along with the introduction of credit, fuelled a huge increase in US consumer spending, permitting Americans to buy for the first time, expensive items that were normally affordable only by the wealthy. Shoppers were able to buy not only new cars, but all their furniture and major household appliances on time payment plans. It was estimated at the time that between 75% and 90% of all these major items purchased in the US, were bought on credit.
New millionnaires were appearing almost daily as the New York Stock Exchange continuously soared to new heights. But then when the stock bubble finally burst, as all bubbles will eventually do, this Magical World of Disney vanished literally overnight.
The US Stock Market Crash of 1929 was the beginning, and the main cause, of the 1930s Great Depression.
It was excessive US credit - overindebtedness - that created the bubble, and when the bubble broke it was the subsequent severe monetary contraction that created the 1930s depression. Readers should note that it was the same scene for the 2008 financial crash, except the more recent bubble was in real estate instead of the stock market.
The euphoria of the 'Roaring Twenties' and lack of oversight created an enormous stock bubble that finally exploded on Oct. 29, 1929 and wiped out $40 billion in one swoop. Millions of people, and many companies, lost everything.
In the 1920s, stock margins were only 10%; if you had a dollar, the brokerage firms and the banks would lend you $9 to buy stocks. When the bubble burst, share prices fell dramatically and the loans were all called in - but nobody had the money to pay. Banks and brokerages failed as debtors reneged on their debts, and panicked depositors attempted to withdraw their savings, triggering multiple bank runs and more bank failures.
As a direct result of the market collapse and the inability to repay loans, more than 9,000 US banks failed. Bank deposits were uninsured, so millions more people lost their life savings. The surviving banks were too afraid to make more loans and credit dried up, thereby making everything yet worse.
With all the losses of wealth and grave fear for the future, everyone stopped spending, production ground to a halt and millions more lost their jobs, with the higher unemployment (25%+) creating yet less consumer spending. And the US government also stopped spending (to conserve resources in a bad time), and made things much worse again.
When all the banks and businesses were failing, the US passed the Smooth-Hawley Tariffs in 1930, with very high taxes and duties on imports. This killed foreign imports - thereby passing the depression to other countries, destabilising the European economies even further, and led to retaliation which killed US exports. After that, all economies collapsed, and it was only the Second War that put an end to it.
After the Second World War, all nations cooperated in creating what they hoped would be a stable system of currency exchange rates, one that would permit the world's battered economies to redevelop in a safe environment.
The foundation of this system was the Gold Standard, whereby all currencies were fixed to each other and related to the amount of gold actually held in stock. This was done partially to prevent countries from inflating themselves out of debt on the international markets. Net international settlement payments would be made with gold although in practice, gold is not a convenient currency to transport.
Since the US was the largest intact postwar economy and had huge gold reserves, it was agreed that only the US dollar would actually be convertible into gold. Countries would therefore use American dollars for all international trade and settlements, with the understanding and guarantee that these dollars were convertible on demand to gold. A gold standard is not a useful construction for today's world, but it was a creditable attempt to regulate the world's financial system so that a repeat of the 1930s couldn't recur.
During this period, the US$ was in fact functioning as the world's reserve currency, with many countries accumulating substantial dollar reserves to fund their foreign trade, engage in currency transactions and protect their domestic currencies.
But the US once again greatly over-extended itself in living on credit and then levied import taxes and adopted other protectionist measures in an attempt to avoid the strains created. By this time, the US began accumulating large balance of payments deficits which helped to create liquidity in the system but also created intolerable strains on international financing. Not coincidentally, it also began to put great strains on the US dollar itself.
The end arrived in 1971 when the French Government, fearful of the considerably weakened position of the US dollar and concerned for its currency reserves, demanded to have all its dollars converted into gold - as guaranteed by the system.
Instead, the US defaulted on the Bretton Woods Agreement, and on the fixed currency regime itself, and unilaterally terminated convertibility of dollars to gold. Of course, the entire international currency system collapsed. This US default not only left the rest of the world very angry, but holding huge amounts of US currency that now had no fixed value.
The European countries complained bitterly to the US about their losses and the resulting currency fluctuations they had to deal with. Does anyone recall then Treasury Secretary Connally’s famous statement? “It’s our currency, but it’s YOUR problem.”
The world's economies now had no choice but to continue to use their dollars as the reserve currency. Everyone who wanted to trade, had to buy US dollars. The result was that the US was able to sell as many bonds and print as many dollars as it wanted - in fact, to be able to inflate itself out of debt and pass the inflationary pain to the rest of the world.
That 1971 decision left the US free to inflate their money supply and fuel more credit bubbles, but it plunged the world into a decade of ruinous inflation, reaching 20% or more in many countries and interest rates reaching 25% even in stable countries like Canada. The inflation led to, and was ended only by, the severe worldwide contraction of the early 1980s - when oil fell from US$40 to US$10 a barrel.
The severe recession in the 1980s was a direct result of the US default ten years earlier, and was a necessary consequence for a worldwide realignment of currencies and economies. That recession was very severe in many countries, devastating entire sectors of economies - energy, for one - and created enormous hardships and economic losses.
In Western Canada, the center of that country's petroleum industry, the contraction hit so hard and so quickly that house prices dropped by 50% in only 3 months, and those prices did not recover their 1984 levels until the year 2000.
All of that worldwide inflation, all the worldwide recessionary pain, were from the same root cause - the US overextending itself, excessive liquidity fuelled by easy credit, and then passing the pain to the rest of the world. The US has repeatedly and severely damaged the world's economies by its financial irresponsibility. It is usually the same - overextension of credit, living beyond their means, creating and bursting financial bubbles, that has done it.
The 2008 Financial Crisis is still fresh in our minds, and we will focus here only on the essentials and on some details that may not be widely appreciated.
Briefly, the US yet again had a period of cheap money - almost free, this time - coupled with easy credit, and banking and financial systems that had had all reglulations removed and were free to run amuck. And run amuck, they did.
In the 1930s, the bubble that crashed was in the stock market, while in 2008 it was in housing prices, but much else is the same. Interest rates were at historical lows and the financial system turned the credit taps wide open to begin the housing bubble. It is important to understand the incredible extent to which regulations were removed from the US financial system, to permit this crisis to occur.
First, the US banking system was permitted to create off-balance-sheet entities that would mask their existing liabilities, trusting only in the good sense of the bankers to limit risks to acceptable levels. Bankers, of course, have no good sense, and many banks amassed liabilities far in excess of their ability to absorb.
Next, the banks, in concert with house brokerage and home mortgage firms, created securities backed by home mortgages, where many thousands of individual mortgages would be assembled and packaged into a single certificate that could then be marketed to other banks or institutional investors. Since quality-rating agencies were also unregulated, and likely motivated by the same greed, all these certificates were rated AAA+ when in reality they were probably CCC-.
In a normal world, borrowers obtain credit by proving their ability to repay, but not so this time. Normally, a borrower must complete a loan application with full details of employment, income, assets and so on, and on the strength of this information a bank will make a lending decision. However, in this case, the banks and mortgage companies created a new category of loans called 'subprime' - which means 'not very good' or possibly 'really god-awful' in terms of quality.
And, as the French would say, here is the piece de resistance. A borrower could decline to complete a loan application, in fact refusing to give any information about his current financial condition. If he chose to do this, the banks would still advance the home mortgage funds, but at a much higher interest rate. It should not escape the attention of readers that mortgage brokers and mortgage loan companies collected huge fees for completing these 'sub-prime' loans.
Then, to attract even more home buyers and to make even more money in fees, the banks agreed to advance mortgages equal to 100% of the value of a home - so, no down payment was required. Normally it is impossible to purchase a home without a significant down payment, since the quality of these loans can be expected to be very poor. But in this case, since the mortgages were being bundled in large blocks and resold to other investors, nobody seemed to worry about the risks.
So, with virtually free money, the US banking system created the 'subprime' no-down-payment mortgage market to boost its profits, and the resulting artificial demand sent the housing AND financial markets into a frenzy.
At the height of the insanity, homeless unemployed people were buying US$500,000 homes with the expectation of making an easy profit.
As the artificial demand sent prices soaring, Americans saw their home values greatly appreciate, but instead of building equity, a majority of Americans used their homes as ATMs. They re-mortgaged their homes as their property values increased, then withdrew the increased value in cash, and spent the money. It's obvious that this is reckless to the point of insanity, at least in any other country.
One of the most incredible aspects of this unparalleled disaster was that Alan Greenspan, the Fed Chairman, denied its existence. He not only stated there was no bubble in housing, he actually encouraged homeowners to (1) abandon their fixed-interest mortgages at a time of historically low rates and go to variable-rate mortgages that could only rise in cost, and (2) to remortgage their homes and spend the money.
"In an often-quoted 2004 speech, Greenspan went so far as to actively encourage the use of adjustable-rate mortgages and praised home-equity extractions for their role in contributing to economic growth. In fact, rather than criticizing homeowners for treating their houses like ATM machines, he often praised the innovative ways in which such homeowners were "managing" their personal balance sheets."
Quote: "Indeed, the surge in mortgage refinancings likely improved rather than worsened the financial condition of the average homeowner. Indeed, the refinancing phenomenon has very likely been a supportive factor for the general economy."
It is difficult to imagine how a man so intelligent and experienced could be so blind and reckless, not only pushing borrowers into contracts that would inevitably have higher financing costs, but actively encouraging individuals to leverage themselves (much as the banks were doing) by risking the only real asset most of them had - their homes.
And he wasn't encouraging homeowners to refinance and invest, but rather to refinance and spend.
Bizarre as it seems, the only rational explanation would be that his actions were deliberate and done in full knowledge of the eventual result - the further gutting of the American middle class. And for sure, that was the result. Millions of Americans lost their only significant asset, and much of their financial security, by following his advice.
In fairness to Greenspan I suppose we might say that many Americans would have refinanced and spent anyway, but surely he bears a significant part of the responsibility for millions of wrecked lives and futures.
And of course when the bubble burst and house prices fell, they were wiped out, as you would expect. Today, about 35% of all US homes have negative equity - the mortgage is larger than the property value - mostly because Americans repeatedly used their homes as ATMs.
Borrowing for consumption is a perilous road, unlike borrowing to invest, where you can repay loans from your profits. When you spend tomorrow's money today, the demand is artificial and can continue only if everything continues to rise - wages, house prices, stock prices, everything. Otherwise you eventually reach bankruptcy.
And that was naturally one of the first results of the bursting bubble - personal bankruptcies rose to an historical high, and many millions of Americans lost their homes. But it didn't end there. All of the securitised mortgages now in the hands of banks, insurance companies and other institutions around the world, had values much less than anticipated. As home prices dropped, increasing numbers of owners simply turned their houses over to the banks and walked away from the debt. Of course, the housing market collapsed and the underlying mortgages were reduced in value by perhaps 50% or more.
The collapse of the housing market naturally meant the collapse of the construction industry as well, creating massive unemployment and adding to an already badly damaged economy. And since the US economy is so dependent on consumer spending, unemployment levels in the US are now almost as high as during the Great 1930s Depression.
Many mortgage firms and banks went bankrupt as a result, and the US government needed to invest more than 1.3 trillion dollars to rescue its banking system from total collapse. And since the US banks had strenuously sold their securitised mortgages off to banks in other countries, the pain spread far and wide. The UK was the most gullible country and suffered the most (after the US), but other countries were hit quite hard as well. Iceland is essentially bankrupt, and many European countries are economically fragile because of their purchase of the unregulated US securities.
Some countries like Canada and China, had banking controls that prevented such disasters and they emerged more or less unscathed from the crisis.
After the crisis subsided, it was very interesting to read the assessments in the US Right-Wing media, of the causes of this worldwide calamity. Much of the US press, and many US politiicans and senators solemnly stated that the 'real cause' of this mess was that 'the Chinese save too much.' In other words, if the Chinese people had been spending all their money rather than saving it, the Chinese government wouldn't have had the cash to continue financing the US trade deficits, and the US wouldn't have had a problem.
It was a stunning shock to me to read an article by Paul Krugman, the now more or less discredited (fake) Nobel Prize winner, in the New York Times - solemnly stating that a major cause of the worldwide financial crisis was the fact that Chinese people save too much. I cannot immediately recall a more striking example of an economist deserving ridicule than this. /TD>