CAPITALISM has learned to live with crises and through crises; but some of them are epochal. Such was the Great Depression (GD) of 1930s. Will the one that is currently unfolding prove to be another?

Take a look at the timeline of disaster appended at the end of the pamphlet. You will see how it started as a mild drizzle and high wind back in late 2006 and gradually gained strength to become a gale storm. No developed country was spared, none of the numerous measures taken by the Bush Administration and financial authorities of the G-7 over more than a year worked, and in late 2008 something like a category five hurricane devastated the world of high finance. Veteran Nobel laureate Paul Samuelson had good reason to observe, "This debacle is to capitalism what the fall of the USSR was to communism."  

Proximate Causes

Fannie and Freddie

To put it very simply, titans like Lehman Brothers, AIG Insurance, Fannie Mae and Freddie Mac failed because at the hour of need they could no longer raise money from the market to roll over their short-term debt.

Being over-exposed to the sub-prime mortgage market and relying too much on derivatives -- instruments derived from the performance of some distant asset—hence the generic name “derivatives” -- they suffered huge losses and lost the trust of the market. Investors became reluctant to lend money even to these prestigious financial institutions. Failing to meet their obligations, essentially they went bankrupt, though in most cases they were rescued by the government.

The "sub-prime mortgage market" or "sub-prime loans" refer primarily to housing loans to those who could hardly afford them and in which the initial interest rate was sub-prime (very low) to begin with, but escalated over the duration of the mortgage on the assumption that as the borrower progressed career-wise there would be an increased capacity to pay instalments. The sub-prime loan instruments were then "diced and sliced" (i.e. mixed up with other more viable loans) and the resultant derivatives were sold on by the original mortgage institutions to other banks and financial institutions. Thus emerged a shadow banking system. The new breed of derivatives generated by dicing and slicing of sub-prime and other risky loans were expected to distribute the risks among many financial institutions and thereby minimise the risks shouldered by each.

This strategy allowed financiers to circumvent regulations and generate easy credit by taking high risk bets and offloading the risks on to others. When, with the collapse of the housing bubble and an avalanche of defaults by sub-prime borrowers, the 'bets' began to go wrong, the pyramid of deals began tumbling down. More than once during 2007 and 2008 the US government sought to stem the tide by helping indebted homeowners, but in vain. The whole process snowballed and led to the September 2008 debacle followed by generous bailouts.

Strange as it may seem now, the high risk strategy involving excessive sub-prime loans and an endless web of securitisation or derivatives-creation was not restricted or regulated by any public or private authorities. Rather, this strategy was praised as a sure way to prosperity -- both for the firm and for the country. Announcing its 2005 Annual Awards -- one of the securities industry's most prestigious awards – the International Financing Review (IFR) said, "[Lehman Brothers] not only maintained its overall market presence, but also led the charge into the preferred space by ... developing new products and tailoring transactions to fit borrowers' needs.... Lehman Brothers is the most innovative in the preferred space, just doing things you won't see elsewhere."

Yes, Lehman became too smart and that's why it met the fate it did, calling back the memory of Nobel-prized Long Time Capital Management (see section "Explosion of Credit and Speculation Today"). Similarly, the US as the leader of the global North blazed the trail in these "innovative" activities, reaped the highest profits for some years and is now paying the highest price for economic adventurism.

Aftershock: Madoff's Ponzi scheme

The weeks-long earthquake was followed by an aftershock that was mild in dollar terms but took a heavy toll of confidence and legitimacy. Wall Street broker Bernard (‘Bernie’) Madoff, former president of NASDAQ, recently confessed to pulling off the biggest fraud in history, a $50 billion dollar scam. For almost four decades he built up a clientele that included many multi-millionaires and billionaires from Switzerland, Israel and elsewhere, as well as the US’s largest hedge funds. To put up a veneer of genuineness, Madoff imposed rigorous conditions on potential clients, such as recommendations from existing investors. Madoff’s standard message was that the fund was closed…but because they came from the same background (board members of Jewish charities, pro-Israel fund raising organizations or the ‘right’ country clubs) or were related to a friend, or existing clients, he would take their money. He embezzled the entire money, and paid the returns due to the old investors from new cash flow. He only dealt with a limited clientele of multi-millionaires and billionaires who kept their funds in for the long haul; the occasional withdrawals were limited in amount and were easily covered by soliciting new funds from new investors fighting to have access to Madoff’s money management.

Bernard Madoff’s game plan is called Ponzi scheme after Charles Ponzi, an Italian-born American immigrant who promoted an investment plan in 1918-1920 that traded postal coupons. Rather than paying investors from legitimate investment returns, Ponzi used to pay out early investors with money collected from new investors. He was found guilty and imprisoned in 1920. In Madoff's case the rug-pulling was provided by the huge losses suffered by some of his clients in other, i.e., non-Madoff investments in the wake of the financial crisis. When many of these clients sought to sell some of their apparently performing Madoff assets to help offset other losses, the scam exploded.

Madoff’s long-term, large-scale fraud was not detected by the Securities and Exchange Commission (SEC) despite its claims of at least two investigations. As a result, there is a total loss of credibility of this watchdog. The swindle has further eroded confidence in the markets. It has drawn as much anger for the money lost as for the fact that the world’s smartest swindlers on Wall Street were completely ‘taken’ by one of their own. Their self-image that they are so rich because they are so smart was utterly shattered.

But the most serious impact of the revelation lies in the growing awareness that the United States government too manages its finances largely on the Ponzi principle. Since 1985 it has been importing more than it exports. That is to say, as a nation it consumes more than it earns. The fallout is that for years on end its national debt has been soaring. As existing debt matures, these are repaid by issuing new debt, i.e., US Treasury Bills. Interest payments on existing debts are also made by selling new debt to investors. If – as happened with Madoff – a large number of US creditors want their money back, the era of American "deficits without tears" will come to an end. In such a scenario, the world’s biggest debtor -- just like Orange County (US) in 1990s and Iceland recently – runs the risk of bankruptcy.

 (Acknowledgement: this section is partly based on “Bernard Madoff: Wall Street Swindler Strikes Powerful Blows for Social Justice” by James Petras, available on his website)