Friday 12 September 2008

Freddie, Fanny, and the end of Capitalism (as we know it!)


It is often said that the 1980s was a decade that demonstrated that Soviet style Communism was unworkable. The decade culminated with the fall of the Berlin Wall and the collapse of the Soviet Union itself. This was followed in the 1990s by a decade that showed that Russian style Capitalism could not work also. The financial repercussions of the Russian Default in 1998 and the subsequent LTCM crisis placed great strains on the international financial system. The 1990s was followed by the current decade where large financial imbalances have developed within the world economy. These have now resulted in the nationalisation of Freddie Mac and Fannie Mae, who together underwrite 80% of US residential mortgages. What are the long term consequences of this?

Looking at the short term first, the action has been undertaken to restore confidence in the US financial system – particularly regarding domestic residential financing. The cost to the US taxpayer of this intervention is subject to much debate, depending upon the assumptions made about how badly the situation may develop. The estimates range from $300 billion to $1.6 trillion. To put this into perspective, it would equate to between 10% and 50% of the long term cost of the war in Iraq, but it is a bill which has a much shorter timescale for payment. It is not unreasonable to believe that, whoever wins the election in November, their ability to act as President will be seriously circumscribed by financial constraints handed to them by the outgoing Administration. The pessimists might say that the new Administration will almost be doomed to failure.

Although the intervention may cost the US taxpayer between $300 billion and $1.6 trillion, the Federal Government doesn’t actually have the money to pay this bill. The Federal deficit is currently heading towards $500 billion a year and the national debt is growing significantly. Who, we might ask, is going to finance the intervention? In recent years, we might have answered that the East Asian central banks - swelled by trade surpluses - and the Petro economies - swelled by rising energy prices – would provide the cash. However, the East Asian – particularly Chinese – trade surpluses are not as great as they once were. Additionally, energy prices have come off the boil somewhat this year. All of this will act to limit the ability of the Federal authorities to raise finance. It is not unreasonable to suspect that US interest rates, in the medium term, might be a lot higher than they otherwise would have been without the intervention.

If so, then more of America will be purchased by the rest of the world. This is a long term trend that may come to dominate domestic politics within the US. It is one of the mechanisms by which other international players – particularly those in East Asia, Europe, and Russia – will raise their international standing. From our perspective, we see this as a hint that the US unipolar moment is coming to an end. The ‘rise of the rest’, as Fareed Zakaria calls it, is becoming evident through the purchase of T-Bills. By making the Federal government susceptible to potential shifts in confidence, another constraint is placed upon the US President to act within the international arena. The US president currently does not need to seek the approval of Moscow or Beijing before acting, but events are moving in that direction.

The Federal authorities intervened in the markets in order to shore up the US (and global) financial system. They needed to do this in order to rectify what economists call ‘market failure’. Market failure arises when freely operating markets generate a sub-optimal and stable equilibrium. This happened in the 1920s, when the world returned to gold at pre-1914 exchange rates. That policy mistake led to a recession that lasted a generation. At the time, the whole future of Capitalism, as an institution, was called into question. We are in a parallel position today. In the 1930s, Keynes came to rescue Capitalism through the development of state intervention – Social Welfarism as we know it today. In recent decades, this Keynesian legacy has been attacked by those who we now call the Neo-Cons, who have developed an aggressive brand of American Capitalism.

American Capitalism has been offered as a solution around the world since the 1960s, but hasn’t gained much traction for one simple reason – it doesn’t work. It does not offer any solution for those market failures that arise on a regular basis. It certainly offers no hope for the largest market failure facing humanity today – that of Climate Change. We now see, through the nationalisation of Freddie Mac and Fannie Mae, an admission from the US Federal government that American Capitalism does not work. We ought not to celebrate too much just yet. The Keynesians came to the rescue in the 1930s and 1940s, but there is no parallel school of thought today. Perhaps necessity will generate it? Perhaps it is time for China, or India, to take the intellectual lead?

It seems ironic, almost comedic, that President Bush, the archetypal Neo-Con President, has come to cause the destruction of that which he cherishes most – American Capitalism. They say that the Gods first send mad those who they wish to destroy!

© The European Futures Observatory 2008
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