Systemic breakdown crisis

In Surviving the Cataclysm, my 1999 study of the world financial crisis, I developed the distinction between collapse and disintegration. A collapse can be very serious, like the Wall Street crash of 1929. Prices plummet, but the exchange still remains open for business. Disintegration is much more serious, like the British default of September 1931 that swept away the only monetary system the world had in those days, or the German hyperinflation of 1923, which wiped out the entire German middle class.

The US crash of 1987 was a classic collapse, and it was followed by a short recovery of sorts. What is happening today looks much more like disintegration, meaning that credit markets, including bond and junk bond markets, have partly ceased to function as far as non-government securities are concerned.

The discredited Bush administration has counted for very little in this crisis. Treasury Secretary Hank Paulson, a Goldman Sachs insider, said in the early phases of the panic that the subprime crisis was �contained.� At a later point Bush commented that he had been told that there was a �soft landing� ahead. The only thing that Bush was sure of was that there should be �no bailout� -- and this is now the Republican line, no matter how many ordinary families were thrown out on the streets. As for the financiers, they get their bailouts through the corrupt Federal Reserve.

Not just one bankrupt hedge fund, but two dozen -- for starters

Back in September 1998, at the time of the Russian state bankruptcy around bonds called GKOs, Long Term Capital Management (LTCM), a Connecticut hedge fund, went bankrupt, blowing a hole of several hundred billion dollars in the world banking system. LTCM used high leverage and the Black-Scholes model to place gigantic bets on currency movements. If Greenspan had not rushed in with billions of Fed money to carry out a backdoor crony bailout, the interbank clearing systems of the US, UK, and perhaps Japan -- known as CHIPS, CHAPS, and BoJ Net -- would have jammed up, and the hearts of the financier universe would have ceased to beat, leading swiftly to world economic chaos and depression.

But this time it is not one LTCM, but two dozen highly-leveraged hedge funds which have blown up or are about to. Prominent among them are the so-called quant funds, which bet $10 billion and up on financial fluctuations using computerized predictive models. Prominent among these is Renaissance. The quants complain that their models, which are supposed to incorporate 45 years of market history and experience, are now failing to forecast what will happen next, and losses are mounting. The reason is that we have now encountered a cataclysmic singularity which has not been seen in more than half a century -- the beginning of the end of the US dollar. To find a financial earthquake comparable to the present one touching the leading currency of the world, we must in fact go back to the disintegration of the British pound in September 1931.

In recent days, reality has filtered through, even on CNBC. Commentators have warned of �systemic risk if a big bank blows,� �the end of the world,� �depression,� �Armageddon,� �panic,� �the Hindenburg� (the dirigible, not the signal), �a return to 1990� (when Citibank was bankrupt and secretly seized by the Controller of the Currency), the crash of 1987, the hedge fund crisis of 1998, and a �credit crunch.� �Bond traders are afraid.� �Wall Street is afraid.� Led by Jim Cramer with his celebrated on-air psychotic episode on the afternoon of Friday, August 3, Wall Street has been heaping insults on Helicopter Ben and demanding that he open the cash spigots, cut the fed funds and discount rates drastically and quickly, and reassure the stockjobbers that backdoor crony bailouts will be available for all, starting with the too big to fail, like JP Morgan Chase and Citibank.

The tip of the iceberg: Financial institutions in trouble

3 Bear Stearns hedge funds

3 BNP Parisbas funds

3 Goldman Sachs funds: Global Alpha, North American Equity Opportunities, North American Equity Opportunities

Sowood hedge fund -- absorbed by Citadel to mask impact

Bowa Commercial Bank, Taiwan -- seized by regulators

Renaissance (quant)

Luminent

Westdeutsche Landesbank hedge fund

IKB Industriebank, Germany

Deutsche Bank ABS hedge fund

AQR Capital Management (quant)

Washington Mutual

Countrywide

American Home Mortgage

Basis Capital

Absolute Capital

Macquarie Bank of Australia

Homebanc

Man Group (UK)

How to stop the depression

What needs to be done first of all is the commitment that not one nickel of public funds should be spent on bailing out bankrupt and panic-stricken junk bonds and other paper. The US needs a uniform federal law stating quite simply that, unless and until the president can certify that the current world financial crisis has been overcome, any and all foreclosures on homes, farms, businesses, hospitals, and infrastructure are banned. This would be accompanied by a debt freeze or debt moratorium on payment of principal and interest, again for the entire duration of the crisis. Something similar was done in the New Deal. The interests of bankrupt banks and mortgage lenders must yield to the social imperative of not evicting 10 or 15 million people over the coming months. No bailout of the financiers. Just a law that stops foreclosures, and lets the financiers, not the people, fend for themselves.

A federal ban on foreclosures is obviously a measure in the New Deal tradition. A monetarist follower of Milton Friedman or von Hayek, by contrast, would say that the homeowners who default should be thrown into the street, so that the market can work. A Malthusian might care only about the carbon footprint of the homes involved. A Mexophobe would rant that illegal aliens might get some of the money. In this wasteland of ideas, the New Deal approach emerges as the only one consistent with human life and human civilization in such a crisis.

Republican Ron Paul, interviewed on August 10 after the close by the infamous Kudlow, blamed the credit market panic on interest rates which had been too low. Paul should recall that any interest rates above 5 percent, as charged on these mortgages, are historically very high. (During World War II, for example, successful New Deal policies allowed a typical 2 percent yield for a 10-year Treasury note, with other rates in line with that.) Paul was adamant that there be no bailout, but did not distinguish between help for ordinary people facing foreclosure and eviction on the one hand, and bailouts for predatory financier sharks on the other. His only advice was to �let the market liquidate bad debt and bad investment� -- which, under current conditions, will mean that more than 10 million people will be thrown out on the street during the next few months. One hears an echo of monetarist Andrew Mellon, Herbert Hoover�s Secretary of the Treasury, whose advice on how to deal with the Great Depression was �Liquidate labor, liquidate stocks, liquidate real estate. . . ." Those on the receiving end of such �creative destruction,� as Schumpeter called it, have generally lost their enthusiasm for monetarism.

Paul mocked warnings that �poor people are losing their homes� -- a sadly Dickensian moment, since that is just what is happening to 10 million Americans. When asked how much he would like to cut federal spending, Paul said that under his presidency it would come down by �50-60-70 percent� -- figures which seem to bode ill for the future of Social Security, Medicare, Medicaid, food stamps, unemployment insurance, WIC, Head Start, S-CHIP (medical care for poor children), TANF (what is left of welfare for mothers with dependent children), and other programs which keep many Americans alive. The Republican line from Giuliani to Paul is that these institutions are part of the hated �nanny state.� When asked for specifics about what he would cut, Paul mentioned the abolition of the Department of Education, a favorite target of Republicans. Does that include Pell grants and federal support for subsidized Stafford loans, which are the only way the ghetto poor and much of the middle class can hope to send their children to college? No help here for victims of the current economic breakdown crisis, but Kudlow said that this approach would be well received on Wall Street..

GOPer Ron Paul has said that he admires the late Ohio Senator Robert Taft, �Mr. Republican,� who was like many in his family a member of Skull and Bones. One wonders if this admiration includes Taft�s sponsorship of the infamous union-busting Taft-Hartley Act, which has allowed many southern states to effectively block union organizing with so-called �right to work� laws, thus greatly facilitating the demolition of the US labor movement over recent decades. Taft-Hartley has been the key to the race to the bottom in wages and working conditions in this country. It should be repealed and replaced with a modern version of the pro-labor Wagner Act, which made it easier for workers to organize, bargain collectively, and defend themselves. Repeal of Taft-Hartley would be a first step towards rolling back the low-wage Wal-Mart/McDonalds model for the US economy.

The uptick rule of 1934 abolished -- just in time for the panic

In an irony of history, traders in the Chicago futures pits have been complaining to CNBC about the abolition, only a few weeks ago, of the 1934 New Deal era rule which had required short sellers to wait for an uptick in the stock they were targeting before they could complete their trade. The rule change had produced disruptions and uncertainty, the trader complained on CNBC. The New Deal rule, one of the final vestiges of the regulations introduced after the Great Crash of 1929, was one of the last factors saving today�s finance oligarchs from themselves. Once the uptick rule was gone, the death agony of the current system entered a new phase.

Worldwide asset bubble

Tiresome commentators have been prating on ad nauseam about the unprecedented worldwide boom. What we have in fact been witnessing since Bush�s attack on Iraq has been a world asset bubble, benefiting derivatives, hedge funds, stock and real estate speculation, junk bonds, and other paper instruments.

In the real world, 2 billion people, a third of the world, have to get by on less than $2 per day. Some 40,000 human beings per day do not make it, and succumb to starvation, malnutrition, or diseases like dysentery and diarrhea which can be cured for pennies. Under almost two decades of globalization, this situation has been getting worse, not better. That is the big picture from which all real analysis must start.

As for the United States, the living standard has fallen by about 65 percent since the beginning of the current reactionary political cycle with the coming of Nixon in 1968. The US is currently running a merchandise trade deficit of between $800 and $900 billion, heading for a trillion dollars per year soon. This means that the US has to borrow more than $2 billion per day just to keep sucking in food, consumer electronics, and services from the rest of the world. The foreign dollar overhang is enormous: about $1 trillion each in Japan, China, and Saudi Arabia, who now in effect hold a mortgage on the USA.

On top of all this, the US is already thoroughly deindustrialized. Steel, chemical, and auto are now a shadow of their former selves. Industrial employment has dropped to the lowest levels in well over a century. The US industrial economy ended when Volcker ran the Federal Reserve and instituted a 22 percent prime rate in 1978-1980. As the dollar falls, we will hear commentators assuring the public that a collapsed currency will mean that US exports are cheap. The problem is that there are almost no factories left to produce anything that might be exported, so these benefits cannot accrue.

The collapse of the auto industry at the root of today�s crisis

The big event, the great economic watershed of the last two years, has been the demolition of the auto industry, the heart of the US postwar economy. Not just the Big Three have been hit hard, but also suppliers like Delphi, Lear Corp., Tower, and Collins & Aikman have been gutted by predators like Cerberus and Wilbur Ross. During the Bush years, 300,000 industrial jobs have been lost in auto.

But the tragedy does not stop here. As the Minneapolis bridge collapse tragedy, the New York steam pipe explosion, and the Utah mine disaster remind us, this is an economy approaching the point of actual physical breakdown, that is to say of thermodynamic collapse. The interstate highway system with its bridges and tunnels is in ruins. Freight rail, passenger rail, and commuter rail are junk heaps. The electricity grid goes into brownouts and blackouts on hot summer days. Commercial aviation has passed beyond the breaking point. Water systems, from the Mississippi levees of Katrina to the cryptosporidium-laced water of Washington, DC, are appalling.

There is a deficit of about 1,000 modern hospitals in rural America and in the inner cities, but viable hospitals are being shut down all the time because of predatory financier incursions -- closing that need to be stopped in their tracks by that federal law forbidding foreclosures, however camouflaged.

This is an economy decades deep in post-industrial rot, running an infrastructure deficit of $10 trillion and probably much more. The private sector has already struck out, as in the case of the high-toll Dulles Greenway near Washington, DC, during the 1990s, and in the looting of the fixed capital of the freight rail system by predatory management.

What is to be done? Let the venture privateers build the Trans-Texas corridor? Call in the hedge fund vultures and privatize the Indiana turnpike, guaranteeing only that money will be siphoned off to the pay greedy venture capitalists located based abroad? Tell people they should walk or use bicycles? Or take the New Deal approach, which would rebuild infrastructure with 30-year 2 percent loans from a special window at the nationalized Fourth Bank of the United States, the former Federal Reserve. This would include giving every US city a comprehensive urban mass transit-interurban train system with the goal of saving the billions of man hours lost to traffic jams and road rage, while taking perhaps one-third of cars off the roads during rush hours by offering an attractive commuting alternative.

Breakdown stage of globalization

Under the globalization of the 1990s, the system lurched from one brush with systemic crisis to the next -- the Mexico and Orange County crisis of 1994 was a typical example. In 1998, when the globalized system threatened to implode because of the LTCM and Russian GKO crises, Greenspan began citing the danger, not of systemic breakdown, but rather of the Y2K computer glitch, which might cause viable banks and firms to appear bankrupt. Greenspan therefore cranked up the printing presses and flooded the gutters of Wall Street with sloshing liquidity. When Brazil was about to go bankrupt in 1999, Soros demanded a �wall of money,� and he got it. The result of all this was the dot com bubble of 1999-2000; the dot communists went belly up starting in the spring of 2000. The dot com-heavy NASDAQ lost 80 percent of its value.

Greenspan responded to this with a new bubble, this time in housing and real estate. As home prices went into the ionosphere and adjustable rate mortgages and interest-only mortgages were given to applicants of the most modest means, Greenspan celebrated the �wealth effect,� meaning that homeowners were now supposed to take out a second mortgage (or home equity loan) on the additional value of their property, and then spend that extra money in the stock market. The housing bubble got going in earnest with Bush�s attack on Iraq in March 2003, and expanded home ownership was a favorite Republican theme in the 2004 elections.

The Wall Street-London casino economy of hedge funds, derivatives, and pure speculation may sometimes seem to be a separate and self-contained universe, but it is not. It ultimately depends on income flows which have to be derived from the real productive and physical economy of the world -- that is to say, from manufacturing, farming, mining or other production somewhere. Finance oligarchs do not like to be reminded of this, but every few decades a depression or even a breakdown crisis comes calling to remind them of this basic fact. Contrary to what is said on CNBC, the US economy is not sound, and the debt-strapped US consumer has indeed reached the end of the line.

The four trillion dollar hedge fund buyout orgy of 2006

Under Bush, with figures like White and Paulson at the Treasury, Wall Street has forgotten what productive investment in new plant and equipment even looks like. Millions of jobs have been lost to the runaway shop under the auspices of free trade swindles NAFTA, CAFTA, GATT, and WTO.

Under the reign of these financial parasites, we have witnessed an unprecedented boom in leveraged buyout deals, where one group of corsairs used junk bonds to take over an existing company, often firing many of the employees, cutting the wages and increasing the hours of those who remain, introducing speedup, busting unions, terminating health care, selling off parts of the business, and leaving what is left groaning under the burden of crushing debt which has not added anything to technology or other capabilities, but has lined the pockets of Wall Street lawyers and investment bankers. These deals are a microcosm of what is wrong with US vulture capitalism today: paper wealth for a few gluttons of privilege is maximized, while jobs, wages, working conditions, and productive output in the real economy are mercilessly driven down. Leveraged buyouts and junk bonds need to be outlawed as a public menace. When Wall Street begs for aid in the coming months, don�t forget that they were the ones who for years applauded every time American workers were fired by a leveraged buyout (LBO) pirate.

Since paper profits are no longer invested in anything productive, they flow into these leveraged buyout deals, often called private capital transactions. The peak of this activity came in 2006, when there were $4 trillion in mergers and acquisitions, with $1 trillion of straight leveraged buyout deals. About $500 billion of this frenzy came in December 2006, setting the stage for 2007 to become the crisis year it has now become.

Every LBO or private equity or private capital deal means fewer jobs, lower wages, less buying power, and thus, most to the point, less ability to keep up with mortgage payments. This problem was escalated by the takeover of many of the subcontractors and parts suppliers of the auto industry by predator hedge funds during 2005-2006. It got even worse when battered Chrysler was sold by Daimler Benz to the Cerberus Fund, aptly named after the hound of hell. As the collapse and looting of auto rippled through the economy, the income flows on which the sustenance of the mortgage bubble depended were severely constricted, leading to the current panic.

Next, Part 3: Contraction in real economic activity in the USA

Part 1: Fed attempts to bail out bankrupt Wall Street speculators