Financial Markets around the world continued to tumble again today, following sizeable drops last week. There are several reasons for the falls. They centre on China, Japan and the US. In addition, capitalism has attempted, in recent decades, to provide itself with insurance against its own chaos, against the causes of periodic crises. Whilst these have succeeded in part, – though only really for the truly big capitalists – they have not resolved the basic contradictions of capitalism, but simply pushed those contradictions to a new height.

China

The first cause of the current slide in financial markets can be found in China. The Chinese economy has been growing, at a phenomenal pace of around 10% a year, for the last decade or so. 70% of all capital investment, and of employed labour in China, still goes to the state owned enterprises, but these account for only a minority of China’s output – an indication of how inefficient and labour intensive they are, the result of the contradiction between the forms of a workers and peasants state, where workers and peasants’ have to be kept employed, combined with control of that workers and peasants’ state by a parasitic bureaucracy. At the same time large sections of the economy have been taken out of direct state control. As I pointed out here The Resilience Of Nationalised Property [1] a substantial portion of this has gone not directly to private capital, but to community ownership, which probably means giving more control to local rather than national bureaucrats. The economic development has seen huge movement of people from the countryside to the towns and cities, increasing the size of the working class substantially. In addition, real wages have been rising at nearly 10% a year, meaning that living standards double every 6 or 7 years.

The increasing role of the market, in the economy, has also led to the development of a middle class. That middle class, together with sections of the working class with disposable income, has recently taken the opportunity to engage in one of the favourite pastimes of Chinese people – gambling. This time, gambling on the stock markets. The Hang Seng in Hong Kong is a well-established market, but, in recent years, an increasing number of Chinese companies have been listed on the new Shanghai Exchange. The small number of listed stocks, the rapid growth of the economy, and the availability of a considerable amount of liquidity in the world economy has caused a boom, if not a bubble, in Chinese stocks. Recently, the Chinese Authorities made two announcements. Firstly, the Authorities are anxious about the growing disparity between rising living standards in the towns and cities compared to the countryside, and the potential social conflict that could arise. The planners are attempting to resolve that by diverting resources to large projects, aimed at developing the Chinese interior. But, the planners have also announced that they intend to, again, try to curb the rapid industrial growth, by raising interest rates, and imposing more direct controls over credit creation. The planners have had some success in doing that in the past. The other thing that they have announced is that they intend to impose controls over what are described as “illegal stock market activities”. It is not altogether clear what this means, but it appears to mean controlling the extent to which people can buy shares on margin i.e. that they borrow money in order to invest. Margin buying and selling always causes an exaggeration of market trends when prices are rising or falling rapidly. The borrowing allows more liquidity to go into share purchases, pushing up prices higher than they otherwise could have gone, whilst, when prices are falling quickly, people facing margin calls i.e. the need to pay back the money they have borrowed, need to sell quickly their shares thereby exacerbating the fall. One of the fears is that it was such controls in 1929, which were thought to have been one of the catalysts for the Great Crash.

These moves in China caused the Shanghai market to fall by 9% in one day last week, with subsequent large falls on other days. Normally, this would not necessarily have any significant knock on effect on world markets because of the small size of the Shanghai market. However, other aspects were also more significant for the world economy. Firstly, there was concern that the fall might have a knock on effect on the Chinese economy. If optimistic Chinese investors became pessimistic that might also be passed on to Chinese consumer sentiment, slowing Chinese consumption, and the Chinese economy. That means lower demand for all those things, which have been doing well in recent years, such as sales of oil, copper, and other raw materials needed by the booming Chinese economy. Together with the stated intention of the Chinese Authorities to slow down economic growth, these fears were heightened. So there was a knock on effect on those companies, largely big Western companies such as Oil Companies, and Miners, that supply those commodities. This set in train large falls on Western Stock Market indices in which these companies are heavily represented.

Japan

The second place where the cause of the falls can be traced to is Japan. For the last 15 years Japan has been in almost constant recession, with prices deflating. To combat this, the Japanese Authorities have had a policy of zero interest rates – which means with falling prices actually paying people to borrow money. The result has been a huge increase in Japanese Money Supply during that period that has fuelled a liquidity boom in the world market. As Marx explained the more paper money that is put into the economy – and credit is the same as paper money from this perspective – compared to the amount of real money i.e. gold that should have been put into circulation, the more the value of that paper money falls i.e. inflation. See here [2]. In fact, during this period, consumer prices around the world have not inflated due to the huge increase in supply of consumer goods put into the world economy by China and other newly industrialising Asian economies. But, a large amount of this liquidity has found its way into asset prices i.e. the prices of things like houses, shares and other types of investment.

This zero interest rate policy has created a strange phenomena. It is called the Carry Trade. What happens is this. Suppose you want to borrow some money. If you are a big enough player you can borrow money in Japan at effectively a zero rate of interest. You could then invest this money into the Government Bonds of some other country that pay a high rate of interest, usually US Bonds, although the Bonds of countries like Australia have also been favoured. In other words you are given money for free. Because prices in Japan have been deflating, and because there was no prospect of Japanese interest rates rising the Yen has continually fallen in value against other currencies like the dollar, and the Aussie. This means that when investors come to pay back the money they have borrowed they also benefit because they have to give back fewer YEN at the new exchange rate.

Over the last year or so, the Japanese economy has been clawing its way out of recession, largely on the back of export growth. So, the Japanese Authorities were still in no rush to see the Yen appreciate which would have stalled that growth. They have been happy to keep printing more money to buy up US Treasuries thereby covering the US’ increasing debt with Japan and the rest of the world for the things it buys. This keeps the Yen down versus the dollar. But now, fearful of inflation with so much money sloshing around, and also fearful of what might happen with so much money tied up in what is an increasingly bankrupt and indebted US economy, the Japanese authorities have begun to slowly raise interest rates. First by a quarter point, and last week by a further quarter, bringing them to ½ per cent.

This has led to fears that those that have engaged in the Carry Trade could get caught. As long as the Yen fell, a few percentage points difference in interest rates was free money. But a weak dollar reflecting a weak US economy, together with a strong Yen could quickly wipe out that advantage if the Yen rises against the dollar by say 5 or 10%. Consequently, those invested in the carry trade began to unwind their positions, to repay their debts. But this necessarily in itself also pushed up the value of the Yen, and reduced the value of the dollar. As huge sums of money are involved in the carry trade this set off fear of what the consequences could be for the value of the dollar, and what the Federal Reserve might have to do to defend it against a precipitate fall – remember in Britain when George Soros attacked the value of the pound before Britain left the ERM interest rates were driven up to 15 per cent in order to try to defend the pound. At a time when the US economy is already slowing down sharply on the back of the rises in US interest rates implemented gradually over the last couple of years, such a sudden increase would certainly send the US into a serious recession. Consequently, share prices in the US sold off on the back of those fears too.

The US

Over the last 10 years the US has seen increasing de-industrialisation as its manufacturing base has been transferred overseas as part of globalisation, and as its domestic industries have not been able to compete against low wage economies in China and elsewhere. Real wages, for ordinary workers, have, in fact, been stagnant or falling for 30 years, but still the US remains uncompetitive, as its high wages and the high cost of private medical insurance cripple it even against Western Europe. In some areas such as technology it still leads the world, but this has not been sufficient to outweigh its increasing reliance on imported manufactured goods to meet the needs of its consumers.

As with Britain, the effect of this on the economy, and on its people has been covered over by a massive amount of borrowing both by the state, and by individuals. This borrowing has been facilitated both by low interest rates in the US, and the creation of large amounts of credit, and by the huge amount of liquidity produced by Japan with its own zero interest rate policy. From being the world’s largest creditor the US has become its largest debtor, to an extent that it now faces the prospect of an unsustainable proportion of its national product going just to pay interest on its borrowing from foreigners – a situation that normally only Third World countries face. This causes two main problems that have resulted in the current crisis.

Firstly, there comes a point when the foreigners lending the money simply decide enough is enough, that their own interests are no longer served by such lending to finance US consumption of their goods and services. At that point, even if it just means no further lending, the US debts can only be financed by either a huge devaluation of the dollar i.e. effectively paying its creditors back with duff money – which the US has done before e.g. in the 1970’s – or else it has to cover its own borrowing through its own saving. That would mean increasing interest rates substantially to encourage saving, and discourage spending. Either way, the US economy would again be sent into a deep recession.

US consumers have made up for the fact that their wages have been stagnant for the last 20-30 years by borrowing. The huge worldwide bubble in liquidity that lifted asset prices, lifted the value of US homes – as it has in the UK – US citizens then used their homes like a huge ATM machine. They first remortgaged their houses, then remortgaged again, then ran up large credit card debts to be paid off by further borrowing against their homes, and then resorted to ever more exotic forms of borrowing against their homes. The more in debt they became, and the less able they were to pay back the borrowing the more they were forced to resort not to the main banks, and financial institutions, but to the so called “sub-prime” lenders, the people who lend to the less creditworthy, and charge a correspondingly higher rate of interest – the kinds of people who continually advertise on the TV in the UK.

As was the case in the UK in the late 80’s, this is fine as long as house prices continued to rise. But the successive interest rate increases instituted by the Fed have meant that the house price bubble has begun to deflate. People find as they did in the UK in the late 80’s that they have negative equity i.e. that the money they have borrowed against the value of their house is now greater than the value of the house itself. As is the case in the UK, the consequence is that an increasing number of people are defaulting on these loans, and on their mortgages. Last week, 20 of these sub-prime lenders in the US went bust because of bad debts as people simply couldn’t pay them back. Today HSBC has reported that it too has $9bn of bad debts on its US lending.

It was these bankruptcies, which were the main cause of the slide on Wall Street last week. These sub-prime lenders themselves borrow money from other financial institutions. When the sub-prime lenders go bust, the debts to those other financial institutions don’t get repaid either meaning that there is a knock on effect. The consequence is that anyone taking risk with their capital demands a higher risk premium i.e. they want more in return for taking that risk. In short, it means interest rates need to rise. But that will make the credit crunch for borrowers even more severe, and it will hit an economy already slowing down considerably.

Derivatives

What has made the financial markets even more jittery is that over the last couple of decades these same financial markets have become ever more sophisticated. Capitalism is a system at whose core is chaos – by definition it is unplanned. But in order to try to avoid the repeated crises it has suffered the really big capitalists, the few thousand families that control nearly all the productive wealth in the world, have been forced to implement some aspects of socialism, they have been forced to introduce some elements of planning into the system. They have done this both at a micro- economic level, where large companies now operate on the basis of 5 year plans, that plan out investment, marketing and financial requirements, based around projections of sales drawn up on the basis of complex market research and demographics. They have done so at a macro economic level, through the intervention of the state in many areas of the economy, most notably in interest rate and monetary policy, in order to try to avoid falling nominal prices – which are a nightmare for oligopolistic companies – and exchange rate policy, not to mention tinkering with fiscal policy. Even at an international level, some planning has been introduced through the WTO, and other such bodies that try to co-ordinate action globally, though usually with much less success.

But capitalists have also tried to take out insurance against unforeseen losses too. For example, a company such as Ryanair, whose business is dependent on the price of oil can, and has, bought supplies of oil at fixed prices through the Futures Market. This means that companies can buy a particular commodity, in this case oil, at a particular price for delivery some time in the future. Usually such contracts are bought as options. That is the company pays to have the option to buy, and can choose to exercise that option or not depending upon what the real price has done in the meantime. If the price of oil has risen substantially, then the option is exercised allowing the company to buy its oil at the lower agreed price, saving considerably over the actual current price. If prices have fallen the company buys at the current price, and allows its option to lapse, losing the money it paid for the option, just as you lose the premium on your insurance if you don’t make a claim. But, of course for every buyer of an option there is a seller, and if the buyer wins the seller loses.

These kinds of options, known as derivatives are nowadays used in almost every aspect of economic life, as a means of spreading risk. It’s like the bookmaker who lays off a big bet to other bookies. But, as time has gone on, the nature of these derivatives has become ever more exotic and complex. To the extent that even the top bankers now admit that they do not fully understand the way in which they all hang together, and the consequences of some large default. The idea is that because these derivatives can be bought by a large number of investors, including the banks, and insurance companies responsible for managing most peoples pension funds, any crash will be spread out so that it does not fall too heavily on any one institution causing it to also crash and create a domino effect. That is the theory, but in reality no one knows if that is what will happen.

A look in the High Street shows the problem. The Alliance & Leicester are advertising a Regular Saver paying 12% interest. The Abbey are offering a Tax Free cash ISA paying 8%, and together with the Halifax they offer a Regular Saver paying 7%. These are just a few. How can they pay such high rates? The answer is the credit multiplier. For every £1,000 the banks take in as savings they can lend £10,000, because its known that at any one time only one tenth of deposits are called on by depositors. Suppose A deposits £1,000; the Bank then lends £900 to B. B buys £900 worth of goods from A, who then deposits this in the Bank. The Bank then lends £810 to C, and so on. If the Bank lends the full £10,000 at a rate of 5%, they will take in £500 in interest. If they pay A 10% interest on his £1,000 they will pay out just £100, making a net profit of £400 on A’s money being banked with them. Most of the time, this is no problem, but, as the old Westerns used to, sometimes, portray, at times of panic, there can be a run on the Bank, when everyone wants all their money out. Now, the Bank of England, to try to prevent such Bank panics, guarantees those deposits, but they can still occur. With the banks increasingly tied up in this intricate web of international derivatives, it is impossible to say what might happen if a real panic set in. Some idea, however, can be gauged from what happened at the end of the last century with the US Bank LTCM (Long Term Credit Management). It was a company made up of Nobel Prize winning mathematicians, and Economists, who used Game Theory to develop a computer model that they believed was a foolproof way of making money through such derivatives. But it wasn’t. When Russia defaulted on its debt, it set in train a series of events, which resulted in LTCM going bust, and its debts having to be picked up by the Federal Reserve, in order to avoid the effects cascading into other financial institutions. Part of the problem is that such models assume a certain degree of rationality in human behaviour. But often, human behaviour is not at all rational. This is one of the reasons that capitalism has crises in the first place, or at least that what appears rational from the perspective of the individual is not rational from the perspective of the whole. Capitalists invest to increase production believing that they will make more profit, by undercutting their competitors. But, as each does the same, the result is lower prices and rates of profit for all of them. Each capitalist wants to keep wages for his workers down, but the consequence is a limitation of the market for his goods and all capitalists if they all keep wages down. When house prices are rising rapidly individuals think they must buy to get on the housing ladder, or to get a more expensive house, but that is usually the time when house prices are peaking, and waiting for them to be falling is a more rational alternative.

One of the most famous bourgeois economists of the last century, commenting on these kinds of problems in making investment decisions, John Maynard Keynes, said, “The markets can remain irrational for far longer than most investors can remain solvent.” Therein lies the crux. However much the capitalists try to resolve the contradictions inherent in the system, no matter how much they borrow the tools of socialism to do so – and we should encourage such moves so that we can learn the techniques ourselves – the continuation of the ownership of the means of production in private hands, means that those contradictions cannot be overcome. They can be assuaged and mitigated as they have been since the Second World War, but at a cost, and probably at the cost of some bigger crash later on. That is why the answer is not a smarter way of running capitalism, but its replacement with socialism.