Causes of the credit crunch.

Author:Turner, Graham
Position:Features - Essay

The credit shock is reverberating across the industrialised world. The US housing market is suffering its biggest slump since the 1930s. Distressed sellers have seen property prices tumble by up to fifty per cent in some areas of the US. Record defaults and the prospect that more than two million families may lose their home in 2008 alone, signals capitalism's biggest test in the post-war era. In the UK, ten years of growth financed by record borrowing are starting to unravel. Property markets are imploding in Spain, Ireland and across Euroland. And the world's third largest economy, Japan, shows no sign of winning its long, tortuous eighteen-year battle with deflation.

Globalisation predicated on unfettered markets is going awry. The housing bubbles were not an accident, spawned simply by careless regulatory oversight. They were a necessary component of the incessant drive to expand free trade at all costs. Dominant corporate power became the primary driving force for economic expansion. Profits were allowed to soar. A growing share of the national income was absorbed by companies at the expense of workers. And the record borrowing provided a short term panacea, to bridge the yawning wage gap that ineluctably followed. Governments fostered housing bubbles to stay in power. Consumers were encouraged to borrow, to ensure there would be enough economic growth.

With the US housing market in freefall and the UK suffering its first bank run since 1878, the mainstream financial press has been turning in on itself, searching for scapegoats. Regulators, central banks and management at the more reckless banks have been selectively targeted and criticised for their lack of due diligence. The opprobrium heaped on chosen culprits sanctifies and provides redemption for those that failed to spot the inherent dangers in allowing economic growth to be financed by untrammelled borrowing.

But there is no mention of the underlying causes of this explosion in debt. These commentators dare not venture there, out of fear that the contradictions and flaws with the economic philosophy they have espoused will be exposed. Greed is good, but some just got a little carried away. Rap a few knuckles, offer a few sacrificial lambs and let the party recommence. Financial markets have been bailed out before, there is no reason to stop and take a hard look at how we arrived here. That would be too painful and would force recognition of the brutal truth: such an uneven society breeds asset bubbles. Rising inequality explicitly leads to extreme house price cycles. If we want to get off this destructive rollercoaster, the limits to unbridled trade need to be acknowledged. The case for a more even distribution of income has to be accepted too.

The credit boom

The collapse of the dotcom bubble in 2000-01 saw a mere tweaking of regulation, a few token limited fines, and the next wave of speculation was fermented to drive economic growth. Under government sanction, central banks stepped back from the plate and facilitated a cataclysmic accumulation of debt.

With companies given such free rein to drive wage costs down, creating property inflation became a necessary stimulus for economic growth in the Industrialised West. After the precipitous meltdown in high-tech share prices during the early part of this decade, few governments complained when strong consumer borrowing and a proliferation of debt provided the fuel for economic recovery. And few objected as an explosion in credit trading buried in a blizzard of abbreviations--MBS (mortgage-backed securities), CDOs (collateralised debt obligations), CDS (credit default swaps) or SIVs (structured investment vehicles)--allowed banks to conceal the inevitable risks from an unsuspecting and pliant public.

Indeed, rising house prices became symbolic, a modern era indicator of wealth and success. House prices were soaring, we must all be better off. Never mind that debt was rising too. Never mind that house price inflation is a zero sum game. Society as a whole does not benefit from a rise in house prices. Those already on the ladder can only gain at the expense of a growing number unable to reach the first rung.

In the short run, housing bubbles can provide a stimulus to economic growth if they hoodwink people into believing they are wealthier. And governments that have been promoting the free trade and profits first agenda are content to foster the delusion. Indeed, governments rely upon money illusion, hoping homeowners will take a myopic view of their record debts. Witness New Labour's boast--'ten years of GDP growth, the longest for 300 years' (Brown, 2005). Growth was everything, it told the electorate. Runaway house prices were a function of the strong economy and a shortage of properties. A similar refrain was widely uttered in Japan during the late 1980s. Record debt levels did not matter, it was claimed, because property prices were soaring. Just focus on the asset side of the balance sheet. Eighteen years on, Japan is still suffering from that disastrous miscalculation.

Heading into a debt trap?

For the US, the stakes are already high. A two-and-a-half year downturn in the housing market is in danger of spiralling out of control despite the Federal Reserve's belated decision to cut interest rates in the autumn of 2007. The US authorities lost valuable time. Federal Reserve officials were sidetracked by numerous voices claiming inflation would continue to accelerate.

Inflation is not the primary issue, precisely because of the free market policies that feed and nourish property bubbles in the first place. Just as Japan overestimated inflation pressures at the top of...

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