Socialist Economic Bulletin is reproducing three articles on the long term background to the current financial crisis which appeared on the blog Key Trends in the World Economy. This blog is published by John Ross, Ken Livingstone's Director of Economic and Business Policy when the latter was Mayor of London. The views expressed in these articles are, however, the personal ones of John Ross and do not necessarily represent the views of Socialist Economic Bulletin.
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The reason the Paulson package will have no major effect on the financial crisis is easily grasped – it is simply too small to be decisive. $700 billion may sound a large sum, but it is small compared to the size of the markets it is seeking to stabilise.
To put arithmetic to this, the $700 billion of the Paulson package may be measured against the $393,000 billion in financial contracts outstanding at the end of 2007. Many such contracts, of course, merely offset each other, and while this sum indicates the weight and complexity of these markets it is not a net figure. However, the issue driving the financial situation, the crisis in US housing mortgages, is a net lending market of $12,000 billion. The entire Paulson package is therefore not only small when compared to the scale of US financial markets but equivalent to only a six per cent fall in US house prices - and a further six per cent fall in US house prices is not merely possible but even likely.
It is the falling prices of the assets, such as housing debt, held by financial institutions that is the transmission belt to the present fulcrum on the crisis – the sharply deteriorating situation in the interbank lending market illustrated in Figure 1.
The vertiginous rise in interbank lending rates that may be seen during September reflects the market's anticipation of high levels of risk of further insolvencies by financial institutions. This risk, leading to fears of a run on the banks, in turn produced the new element of destabilisation – the 100 per cent guarantees on bank deposits introduced by the Irish and Greek governments, which itself produces a move of assets into the institutions covered by such guarantees and out of those of other countries. In effect Ireland and Greece are avoiding a run on their own banks by producing a run on other countries banks.
The prospect of the passage of the Paulson package totally failed to reverse the interbank lending crisis, simply because it is far too small. In the short term only the state can temporarily sustain the interbank lending markets – by the middle of last week financial firms were going to the Federal Reserve for $409.5 billion in overnight loans and even this led to no downward movement in one or three month interbank lending rates - as may be seen in Figure 1. In the medium term only factors affecting overall US spending power by consumers, government and corporations, and international developments, have sufficient weight to reverse that situation.
But if the financial effects of the Paulson plan will be marginal it will have a deep effect on US politics. The model by which free markets are supposed to operate is that entrepreneurs fairly bear the consequences of both success and risk – if they take the right decisions they profit, if they take the wrong decisions they suffer losses.
This model is supposed to continue to operate even in cases where, for any reason, there has to be widespread state intervention. The reason the rescue of the Swedish banking system in the 1990s has been widely praised in the media, and by economic experts, is because it stuck to this principle. Depositors were safeguarded, but the shareholders of banks that had made wrong decisions shouldered any losses before risk to the taxpayers money that was used to rescue the banking system – that is, tax payers were protected and shareholders took the risk.
The Paulson package stands this on its head. Bad debts will be purchased from banks by up to $700 billion supplied by tax payers. This will improve the situation for shareholders, as they will be relieved of the bad debts, but it is bad for taxpayers - who will be acquiring the worst performing assets. In other words the Paulson plan is the opposite of the Swedish one; shareholders are being protected and taxpayers are taking the risk.
Despite this fundamental feature, if the US financial system were to turn round in the short term then while the Paulson package would be unjust it would not be very serious in its social and electoral consequences. Up to $700 billion of taxpayers money would be spent on bad debts in the short term but then this sum would be returned to tax payers as the purchased assets recovered to better values.
But this is extremely unlikely to happen. As has been noted in previous posts the essence of the present financial crisis is the revaluation downwards of assets priced in dollars. Therefore US taxpayers will not get their money back. As shareholders in distressed US financial institutions will have benefited in the meantime there will therefore be a shift in resources from US taxpayers to various categories of shareholders of distressed financial institutions. This, needless to say, will be unpopular.
This is why the Paulson package will not stabilise financial markets - but it will help sustain unrest in US politics.
This article first appeared as 'The Paulson plan and unrest in US politics' on Key Trends in the World Economy
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