In these days we are witnessing the deepening of an enormous financial crisis, with it’s epicentre in the USA but with consequences for the whole world. In reality this crisis began to appear a year ago, put it had been coming since 2006, and its roots are even prior to that. And we could say that the “fertile ground” for the development of these roots was being ploughed for decades.

In the year 2000, when we published “Mixed Economics”, we dedicated a few paragraphs to what we called at the time “the credit trap”, or the phenomenon through which individuals are encouraged to bring forward their consumption through debt. In a first moment the level of consumption increases (because the people are spending the equivalent of what they earn, plus what they borrow) and in a second moment their consumption drops because their debts restrict their regular spending, in order to generate a saving that lets them pay what they owe, plus the accumulated interest, which in the case of long term credits can double the value of what was borrowed.

This on the one hand generates a transfer of income from the productive economy to the banks, and on the other hand generates successive cycles of expansions and contractions of the economy. Because even as credit expands, increased consumption generates an increase in the real economy, and therefore people increase their incomes and position themselves better to face their expenses and debts, this rhythm of real increase is always less than the expansion of credit and the famous “bubbles” are generated, that unfailingly burst.

When we spoke of these themes in “Mixed Economy”, we also made mention of the level of debt that US society was already suffering, and we mentioned that in some moment it was going to burst. Everything indicates that this moment is approaching. It’s not at all easy to estimate the times of these things; when in 1998 we anticipated the fall of convertibility in Argentina (a moment when the Argentine Peso was forcibly pegged to a value of the dollar), we could make an analysis of a much smaller, much simpler economy and confined to a single country. The US economy on the other hand, besides being enormously bigger and more complex, has had the possibility to “export” its problems, and you would have to have available an unusual quantity of information at a global level, in order to be able to effect more precise prognostics. But there was no doubt that the tendency was towards an increasingly profound crisis.

Before referring to the detonation of the current crisis, we have to understand how US society functions regarding credit, consumption and speculative investment. In this country there is a very rooted culture with respect to debt in order to climb the social ladder (measured through consumption). And for those that have the capacity to save, there is a very widespread culture of investment in shares, investment funds and a whole series of complex financial instruments that ordinary people don’t even understand. In the US the greater part of the population go into debt in order to buy household items, cars and houses; and when they finish paying for them they go into debt again to renew them.

University students go into debt to pay their studies and then pay their debts when they start earning. It’s an indebted society, to the point that at present the average level of household debt represents 120% of annual income; or in other words, on average, if US citizens went a whole year without spending even a dollar, not even for eating, they would still have to work all year and a few months more to pay what they owe. And 75% of this debt corresponds to mortgage debt, the catalyst of the current crisis. But this level of debt of US citizens, is not only internal (among them), but rather it is financed with the enormous deficit that the country has as much in the balance of trade as with their balance of payments, as it is the most in debt government on the planet. Between China and Japan they are accumulating US government bonds of almost 2 billion dollars, due to their trade surplus with this country.

Antecedents of the current crisis

Within this context of a society accustomed to growing indebtedness, on one hand, and to generating investment bubbles on the other, the real estate bubble began to gestate between 2002 and 2005. In those times the Federal Reserve lowered rates to activate the economy, after the negative impacts that were generated by the fears following the attacks of September the 11th. The banks were then able to borrow money at 2% annually and lend at 8% annually to those who wanted to buy or build a house.

It was a great financial business in itself, but the voracity of the bank did not confine itself to this; to capture more and more customers to take out mortgages they relaxed the rules and controls and gave out credit to less solvent people (“subprime” mortgages), and it was the peak of the mortgage business, that made the prices of property increase and increase. But in turn, in order to be able to lend to more and more customers, the banks needed to capture funds in the market, and it was then when they started to offer as guarantees their own customers’ mortgage portfolios. They did this time and time again, and the mortgages moved to become the basis of a whole complex weave of financial instruments that even ended up involving the participation of European banks.

Millions of savers, through banks, investment funds and businesses quoted on the stock market, financed the growth of the bubble, the majority of times without knowing what the end guarantee of their investment was. All of this with the consent of prestigious risk assessors that had been so concerned with disqualifying the emerging economies, that they never warned savers about the risk of these irrational credit instruments of the First World. And all of this was a prosperous business while property was increasing in value and the wheel of debt and the payment of mortgages continued to function. But like any other bubble, one day it burst.

The Federal Reserve started to increase rates to over 5% in order to contain inflation, and so the banks also increased mortgage rates for existing mortgages (that were on variable rates). In the meantime, many homeowners were not sufficiently solvent, they had already begun to default; but increasing interest rates increased the defaults and by 2006 there were 1,200,000 mortgage foreclosures. The value of property, that had reached irrational levels started to deflate, first through the logic of relative values, but this deflation accelerated when many homeowners put their houses up for sale because they couldn’t finance their mortgage repayments.

This drop in property prices resulted in many homeowners having a debt with the bank that was much greater than the value of their house, leading these people to also put their houses for sale, so prices continued to decrease. As of today it is estimated that more than 5,000,000 families are trying to sell their house because they can’t pay their mortgages and there are more than 2,000,000 people that are about to have their house repossessed.

When the crisis erupted in August 2007, it was estimated that there was an accumulated default of more than 500,000 million dollars in the mortgage market. But much greater was the loss of value of the bonds and shares that were supported by the then baptised “junk mortgages”. In other words, many of the banks linked to the housing business could not pay their debts because their assets had evaporated, tied up in irrecoverable and devalued mortgages. And in this complex financial weave, the domino effect began to drag to breaking point many entities related in some way with these financial instruments supported by a fragile bubble. The most resonant cases were Freddie Mac, Fannie Mae, Bearns Stearns and more recently Lehman Brothers and AIG, but there were hundreds of entities affected in the USA and some in Europe that had to be propped up.

And this domino effect is already one year old, and has not reached its end. The US government and the Federal Reserve are injecting hundreds of thousands of millions to moderate the earthquake, but it’s never enough, and the mortgage crisis contaminated the entire financial and stock market. Investors took their money out of the banks and investment funds because of panic and loss of confidence and in so doing weakened the financial system even more.

The bearers of bonds or shares tried to sell them in order to liquidise them, or because they foresaw a greater depreciation in value, and in doing so, they depreciated more. In other words, it is surpassing the size of the mortgage problem (in itself enormous) to take on the dimension of the self-fulfilling prophecy of a bank and stock market run that is generating chains of bankruptcies. And this is the problem that confronts the USA today.

Where the crisis will reach?

It is very difficult to know when it will reach the bottom. In the first place because we still don’t know the full extent of the contamination with these financial instruments backed by the “junk mortgages”, given the complexity of such instruments. In second place because besides the original financial problem, the psychological factor of savers’ lack of confidence is appearing, which is much more difficult to measure and predict, and it will continue to provoke runs. In the third place because in the measure that this financial problem deepens, its repercussions in the real economy, basically through the restriction of credit for investment and consumption, and through the population’s loss of capacity to spend, the downward spiral will accentuate. In fourth place, because the inter-dependence between the economies of the world with the USA, is opening a fan of multiple consequences that are feeding each other.

The US economy represents 25% of the global economy, and it is extremely inter-dependent with China, Japan and Europe, which together makes up more than 50% of the global economy directly affected by the crisis. Therefore practically no country will be isolated from the consequences, albeit indirectly and to different degrees. A US recession implies a strong decrease in consumption by the principal purchaser of products made in China and Japan. And a deceleration in the Chinese economy as a consequence, would imply fewer imports of raw materials by this country from the rest of the world. In turn, the lack of confidence in risky investments will affect the flow of investment to the so-called emerging countries. But to what extent and for how long is impossible to anticipate.

The US government, contradicting their own “principles” of liberal orthodoxy, to leave the markets to self-regulate and break those that have to be broken, are resorting to heterodox solutions, injecting hundreds of thousands of millions of dollars in the bottomless barrel of the financial crisis. If they continue to do so, possibly they will avoid the Apocalypse of a new crash, greater than the one of 1929[1], but at the cost of taking their debt as a nation to unmanageable limits. But beyond the lesser or greater magnitude of the spectacular fall, what is sure is a recession and a prolonged weakening in the greater economy of the world.

How will it affect Argentina?

In a globalised economy, the repercussions of such a crisis will reach everywhere, but the magnitude of the rebounding effects, are increasingly less predictable in the short term, and virtually immeasurable in the medium term. For example, the disproportionate increase of international oil prices and raw materials that existed a few months ago, and their recent and abrupt fall, had to do with the fact that many investors fleeing the property market, ran to commodities and created a fleeting bubble in this market, which is now dissolving. But until this capital leans definitively towards some kind of investment in the medium term, it will continue to provoke turbulence that is difficult to predict.

At the moment a lot of capital is going into US Treasury Bonds (that in addition are issuing no-risk bonds to salvage the financial market), because they are considered to be secure, although there are no practically no profits. At the moment Argentinean debt bonds are being sold, in order to lower prices and increase the country risk, and thereby increasing the rate of interest for credit to Argentina. At the moment prices of agricultural products that Argentina exports are going down, through deflation of the transitional bubble, but still prices continue being profitable for producers. But all of this is in this moment. It could happen that when the panic passes, some investors consider that certain projects in Argentina are less risky than the speculative markets of the first world, or maybe not. It could happen that the drop in commodity prices diminishes inflationary pressure, and this may bring us some relief. Surely a US recession will infect China and Brazil, who have a greater commercial relationship with this country than Argentina does; but as Argentina has large commercial relations with Brazil and China, it will be indirectly affected.

But how to measure the magnitude of these indirect effects, if you can’t even calculate the magnitude in those cases directly affected? What we do know is that Argentina is not in the list of those that will be most affected. Because even if there could be problems to obtain credit, this has also been the case in recent years, and nevertheless the economy increased: “living our way”, as Aldo Ferrer puts it. Because even though some countries can diminish the demand for some of the products that Argentina exports today, it has to be considered that before, in some items exportation had to be restricted to assure the internal supply, in other words now it could happen that the lower demand will equalise the export capacity, and not diminish exports so much.

The accumulated reserves of Argentina, and the margin of fiscal and trade surplus it still has, give it a cushion that will allow it to soften, up to a point, the collateral effects of the US crisis. But now, more than ever, we must work on an economic plan and a parallel reform that will assure, besides the fiscal surplus, the productive re-investment of company profits, in order to achieve development and redistribution of wealth, and so be able to counteract with interest any negative effects in sectors more exposed to the international crisis.

Definitely, this crisis of capitalism and globalisation shows once more that financial speculation in the world must come to an end, forcing productive re-investment of company profits. The world can no longer be governed by the tyranny of speculative capital, which generates poverty and chaos everywhere. The world has to advance towards a Universal Human Nation in which the people, through direct democracy, resolve that the immense resources that today are destined for speculation, usury and armaments, contribute to the development that will end poverty. And in this sense we have to be alert, because this financial implosion in the empire is weakening it, but like a wounded beast, with the aim of recovering power, it could try to resort to brute force, even more than has been seen until now.

Guillermo Sullings

(Economist, spokesperson of New Humanism in Argentina)