Apparently the Emperor is Wearing Clothes Again

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You can gauge the kind of month it has been on the world’s financial markets by the ecstatic relief that greets a confident day’s trading. But that was yesterday. Today it looks like poor individual performances and the fear of a recession is going to remove quite a lot of yesterday’s gains.

There has scarcely been a period on markets like this in decades. Sub-editors have worn out their stock of disaster metaphors, while TV economists have repeatedly been called on to explain why this is the worst banking crisis since 1929.

In previous articles, I’ve explored how a combination of poor regulation, cheap money and a shared belief by rich world policy makers in the elixir of efficient markets led to the current crisis. Although it had its roots in the wild excesses of US subprime mortgage lending, in time this will be seen as only the proximal cause. The real cause of our current predicament is the ramified interconnectedness and vast leverage of western financial institutions, and the arcane derivatives they trade in stupefying quantities. World markets had outgrown their national boundaries, and no-one was supervising them particularly closely. The worst predictions of the critics of globalisation came true. Not only was global capital uncivilised, it wasn’t even particularly well-capitalised. In fact, it was a huge edifice built upon debt.

Much as the killing of Archduke Franz Ferdinand of Austria was merely one of several possible triggers which in the early years of the 1900s were likely to lead to war between armed and tense European alliances, so too will subprime mortgages eventually be seen as only one of the possible causes of this crisis. Indeed, as Brad DeLong wrote recently, most economists were expecting a different crisis — one triggered by the huge imbalance in savings and trade between the United States and China.

The novelty of the current disaster — a run on banks by themselves, instead of their ordinary depositors — left policy makers entirely flat-footed. In the beginning central bankers and finance ministers like Ben Bernanke and Henry Paulson misdiagnosed the problem as one of liquidity, and therefore could not understand why flooding the markets with billions of dollars wouldn’t restore confidence. Failing institutions could be bailed out on a case-by-case basis. Policy-makers were unable to grasp that the problem might be much more systemic.

In fact, the problem was much more serious: a crisis of solvency. As the insane levels of leverage of institutions like Lehman Brothers began to unwind, banks all over the world suddenly realised they didn’t understand their own products. Credit default swaps were meant to insure against this current crisis. But if you can’t be sure the institution holding your credit default swaps is solvent, then those positions suddenly becomes a huge possible risk. Banks began refusing to lend to each other. Panic gripped the markets. The emperor was wearing no clothes.

This crisis in financial markets has also revealed just how impotent national governments have become in the face of global capital flows. Although the crisis began in Florida and California housing markets, it spread inexorably to Wall Street, London and then European financial institutions. Amongst the worst affected countries have been Russia and Iceland. The age when national governments could control their own economy has ended — indeed, it is now clear it ended decades ago.

The result has been a transfer of sovereignty: from national governments which are at least elected, to international markets which are not. The economic policies of governments across the rich world are now as much controlled by hedge funds, massive multinational banks and unelected central bankers as they are by elected ministers and parliaments.

This is why Keven Rudd and Wayne Swan, who were initially adamant that the Australian banking system was sound, were quickly forced to move to guarantee the entire domestic deposit base. Similarly, yesterday’s $10 billion fiscal stimulus package announced by Rudd has been forced on his government by the disastrous course of recent economic events. At least most of this money will go to pensioners and families, rather than to bank shareholders.

The other amazing factor of the current situation is the sheer scale of the rescue packages being announced. The US has already promised just under $US1 trillion in bailouts, including the $US700 billion package that passed Congress on its second attempt. The UK is nationalising large chunks of its banking sector and the Eurozone governments have pledged an estimated 2 trillion euros These amazing spending sprees were not voted on. They have been forced on governments by a power base more important than voters: global capital markets.

If there is any good news to be found in the current situation, it is that it might alert ordinary citizens to the magnitude of the power shift away from representative democracy in favour of the power of money. It’s not as though no one saw this crisis coming. In fact, many economists of different persuasions predicted it: including Joseph Stiglitz, Nouriel Roubini and Steve Keen. But the irrational majority preferred to party like it was 1929.

Has anyone noticed the comparison between the financial crisis, and the far broader and more dangerous rolling crisis represented by global climate change? For decades, governments and economists in the sway of fossil fuel industries have told citizens that we could not afford a rapid, costly decarbonisation of our economy. The current crisis has revealed they were lying, as governments of all persuasions have printed monopoly money to bail out banks and mortgage companies. As George Monbiot writes in The Guardian, the coming crisis in natural ecosystems will dwarf the current problems caused by over-generous banks:

"[The] two crises have the same cause. In both cases, those who exploit the resource have demanded impossible rates of return and invoked debts that can never be repaid. In both cases we denied the likely consequences. I used to believe that collective denial was peculiar to climate change. Now I know that it’s the first response to every impending dislocation."

Shares were up yesterday. And even as they go down today, the market seems relevant again, connected to some kind of useful reality. But the leaders of the free world are not breathing a sigh of relief. Doomsday has been temporarily averted. There’s a chance for governments to catch up a bit and plan for the longest term goals that democracies can manage these days: the next election.

Ben Eltham

Ben Eltham is New Matilda's National Affairs Correspondent.

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