The End of the Illusion Prabhat Patnaik

Neo-liberalism specialized in selling an illusion, namely that the unfettered functioning of markets, both commodity markets and financial markets, constituted the best economic arrangement for a society. This illusion had been buried in the 1930s, by the experience of the Great Depression, and by the theoretical endeavours of John Maynard Keynes, a British Liberal and Michael Kalecki, a Polish Marxist. But it was resurrected to serve a specific purpose. This resurrection had nothing to do with any theoretical demonstration of the invalidity of the Keynes-Kalecki propositions. True, the Keynesian prescription for the rescuing of capitalism had turned out to have been problematical, as indeed one would expect with any Liberal panacea for capitalism; but this is not the same as saying that the Keynesian analysis of the ills of capitalism had been proved wrong. The resurrection therefore was a theoretical sleight-of-hand.

Behind this resurrection were financial interests, re-acquiring hegemony in a new incarnation, after the setbacks faced by them during the Depression, war and immediate post-war years. Keynes had called for the “euthanasia of the rentier” and the “socialization of investment”. In his view, the basic fault of the market mechanism was that it could not distinguish between “enterprise” and “speculation”, so that the unfettered functioning of markets made the livelihood of the common people dependent on the whims of a bunch of speculators. Capitalism, whose survival he had wanted, could not, in his view, survive if this grievous fault was not rectified through the institutionalization of State intervention in crucial spheres relating to its functioning. Resurgent finance capital, in its new “globalized” garb, starting from the late sixties, took its revenge on Keynes, and decided to put the clock back. It “sold”, or imposed through agencies like the IMF and the World Bank, its free market ideology all around the globe. While Keynes had wanted finance to remain national, so that nation-States could have the autonomy to pursue employment-promoting policies, “globalized” finance forced nation-States to open their doors to its unfettered movements, and justified it by invoking the illusion of an efficient free market.

This illusion is now over. Two momentous recent developments, coming one after the other, have finished it off, though only one of these has caught serious attention. And this is the threat of collapse of the US financial system, and with it an unprecedented financial crisis in the capitalist world. But the other was no less serious, and that related to the unprecedented upsurge in oil prices (and, associated with it, food prices). Both developments are the outcome of speculation, in one case speculation that made some financial paper worthless, in the other case speculation that caused a flight from financial paper as such into commodities, viz. oil futures (that had a spill-over effect on foodgrains). In what follows we shall look only at the first of these developments, since that is currently in focus.

This crisis, a fall-out of the sub-prime lending crisis in the United States, is exceedingly serious. Alan Greenspan, the former boss of the Federal Reserve, calls it the crisis that happens once in a century. His successor, Ben Bernanke, has frankly admitted, “we have no control any more”. The top five investment banks in the US have ceased to exist in their previous forms: Bear Stearns got taken over through government facilitation some time ago; Merril Lynch was taken over by the Bank of America under the government’s benign supervision; Lehman Brothers, an investment bank with a 158 year old history, declared itself bankrupt; and Goldman Sachs and Morgan Stanley have decided to transform themselves into ordinary deposit-receiving banks. Investment banking as a phenomenon in Wall Street is over. Two other financial giants, Fannie Mae and Freddie Mac have got nationalized to prevent their collapse; and, AIG, the world’s largest insurance company, has survived for the present through the injection of funds worth $85 billion from the government, but this is meant only to give it time during which it liquidates some of its assets to restructure itself into some sort of viable existence. These developments, any single one of which represents a severe tectonic disturbance, have all occurred within a few days of one another. Little wonder then that the world of international finance capital is rocking. The question naturally arises: why has this happened?

The capitalist world is invariably punctuated by financial crises, which necessarily accompany the cyclical crises, irrespective of whether the latter are caused by financial or non-financial factors. So, the fact of there being a financial crisis in which some financial firms go under is not in itself surprising. But there are three additional factors which have been at work in the recent period, each of which contributes towards making the financial crisis potentially far more debilitating, and hence in their totality explain the financial earthquake we are currently observing.

The first of these relates to the short-sightedness of speculators. During any asset price boom, the belief that it would go on for ever gradually gathers momentum; as a result the awareness of risk comes down, and more and more risky positions begin to be taken. Hence instead of such an asset-price boom getting truncated early, in which case the potentially-destabilizing impact of such truncation on the financial sphere would also be limited, it persists, making the financial system more and more fragile, until the end of the boom catches the entire financial system in an acute crisis.

The sub-prime crisis illustrates this point. As the real estate boom in the United States got underway, the euphoria about it began to increase. Financial firms became more and more reckless about supporting it. Credit was available to all and sundry, at one point up to the full value of the property being acquired, which itself was never carefully assessed. To say this is not to argue that credit-giving institutions should be conservative in accommodating borrowers, but merely to underscore the fact that they are swayed by speculative considerations which make them reckless. They give credit in anticipation of rising house prices, since they expect this rise to continue. And when, for one reason or another, the rise in house prices reaches a plateau, the borrowers are caught short. To pay back their loans many of them are then forced to sell their property which brings down property prices. Finally, the time comes when the value of the assets against which the loans are given is way below the magnitude of the loans themselves. This is when the financial papers representing, directly or indirectly, claims upon real estate, are worth only a fraction of their face value, and the financial world gets into a crisis.

The second factor relates to the emergence of a vast “derivatives” market. A loan, say, for the acquisition of a piece of housing property, is typically thought of as a bilateral arrangement, between the lender and the borrower. In a modern financial sector, however, the risks associated with any loan are no longer borne exclusively by the lender but themselves become a marketable commodity. These risks are passed on to others through the “derivatives” market, who in turn pass them on to still others and so on. All this however does not mean that the risks themselves disappear or diminish; what it means is that there is a systematic undervaluation of risk since nobody quite knows what the risk associated with his/her portfolio of assets actually is. This piece of “financial innovation” therefore has the same effect as the first factor mentioned above, namely it leads to an underestimation of risk during any boom in asset prices, which makes such booms more prolonged and more pronounced, and the subsequent collapse in the asset prices more precipitous, and hence more calamitous for the world of finance.

The third factor has to do with government intervention. Whenever such a financial crisis, involving giants in the American financial market, looms large on the horizon, the government steps in to bail out these giants. Such government action may well be dictated by the desire to avoid a recession, but the awareness that the government will provide a bail-out also works in the direction of making financiers reckless, making them underestimate risks, and hence promoting speculative bubbles in the asset-price markets, whose bursting becomes even more debilitating than if financiers had been more cautious and less confident of a government bail-out. Economists refer to this as the “moral hazard” problem. Government intervention compounds the “moral hazard” problem.

Saying this may give the impression that since government intervention compounds the problem, the problem lies with such intervention and not with the market itself. But the failure of the market lies precisely in the fact that it provides the government with such a “catch-22” situation, where if it does not intervene then it has to tolerate a recession, but if it does intervene then it makes things worse for the future.

In short, the tendency of capitalism to face crises because of speculators’ behaviour, which Keynes had written about, has got greatly accentuated in contemporary capitalism. Such speculation has the eventual consequence of making financial papers of one sort or another close to worthless, and this fact threatens not just a few financiers but the entire system through a “domino” effect. Till now we have seen financial crises brought on by such speculative behaviour occurring in particular parts of the world, in East Asia, in Russia, in Latin America etc.; in other words, financial papers, relating to these countries, had become near-worthless. Now, we are seeing a financial crisis arising from the fact that financial paper relating to a sector within the metropolis, namely the housing sector, becoming close to worthless. The implications of the latter of course are far more serious, but the taste of the problem is something which the world has already had.

The illusion of the market being “efficient” may have been given up in the metropolis, but in India brave attempts are being made to make it persist. The importance of government intervention is being played down. But the simple fact remains that government intervention has become absolutely necessary for sustaining the system that has become utterly fragile because of the free run that speculators enjoyed in a free market. And this intervention takes the form of the government’s buying, or providing loans against, certain financial papers at values that the market would not accord them, for, if this was not the case, then there would be no “bail-out”.

The Indian finance minister’s attitude has been quite striking. While claiming that India will not face the damaging consequences of the financial crisis, a fact for which it is not Mr.Chidambaram but the opponents of “financial liberalization”, notably the Left, that should take credit, he goes on to add that India’s drive towards “financial liberalization” will continue! Here we have an obvious case of irresponsible bravado, which becomes possible precisely because his statements carry not an iota of analysis.

In the U.S. itself, even though the government is “bailing out” the financial giants, it will be under popular pressure to inflict some punitive measures upon them, in the form  of a change of management and possibly ownership. But the “bailing out”, even if it manages to prevent a severe financial crisis, will certainly not prevent a recession which appears to have already set in. The state of credit will continue to be difficult for sometime to come, which will only worsen the recession. Even the financial crisis will not be over with the current “bail-out” package. After the Bear Stearns episode every one thought that the worst was over, but it wasn’t. The same perhaps is true of the present. The system of course will recover, but the form in which it will do so is unlikely to be the same as before. And this will open up new possibilities of praxis.