STRUCTURAL CAUSES

and the stories of most countries enjoying export-led growth in the post-war years are linked inextricably with the US market – Japan, South Korea, the east Asian “tigers” as well as West Germany before unification. A look at the list of these countries makes the accompanying political reason clear. The common factor was their military alliance and dependence on the US during the cold war era.

Only slightly different are the Arabian Gulf countries with their assets acquired through petrodollars and held mostly in dollar denominated assets. Although not often mentioned explicitly in polite academic circles, the global status enjoyed by the dollar is sustained to a large extent by the military superpower status of the US. Thus, the bursting of the dollar bubble could have been caused by, say, China as an independent military power with a massive holding of dollars. It did not happen that way, perhaps because of China’s own dependence on the US market as an exporter. Some might even infer that economic calculations have so far dominated China’s assertion of economic nationalism.

Nor was the crisis precipitated primarily through a typical Keynesian or Marxian route of deficient aggregate demand surfacing as under-consumption or overproduction. The bubble might have helped to stimulate aggregate demand, but the fact remains that real investment or consumption did not fall dramatically to precipitate the crisis. It was not predominantly a case of demand deficiency or a profit realisation crisis caused by the growing burden of debt repayment on the household sector, or a negative wealth effect of falling asset or housing prices. Rather the impact of a negative wealth effect was felt as a massive tremor which shook the foundations of the financial sector and destroyed confidence, driving it to near paralysis. We would begin to understand the nature of the crisis only by identifying the main characteristics of the financial system that became so vulnerable to collapse due to falling asset prices.

There are three sets of inter-related facts which seem to capture the nature of this financial vulnerability. First, there emerged a set of financial institutions and companies that were in the lending business almost like usual commercial banks, but had no “lender of last resort”. They resembled instead a shadow banking system which lacked the explicit backing of a monetary authority on the one hand, and escaped largely its regulation on the other. In the true spirit of free market enterprise, finance could go on innovating new credit instruments with little regulation.

Second, without a lender of last resort at the top, innovative shadow banking resulted in what may aptly be described as a circular rather than a vertical network of credit interdependence. It happened basically through a system in which these shadow bankers, especially large investment banks, through mutual underwriting insured each other’s debt with derivatives as the most prominent debt instrument, and then went into “securitisation” of these debts by mixing them in different ways. These debts in different combinations of financial packages were then sold to private parties, including institutional investors, as securities or assets the world over according to their supposed degree of risk

STRUCTURAL CAUSES

ascertained again by private credit rating agencies within the shadow financial system. Thus the whole game could be played within the private financial system virtually without regulation.

Finally, by treating each other’s debt as asset in the capital base for lending, the volume of lending could be expanded enormously. “Low margin, high volume” by pushing loans to more risky borrowers became the name of the game. This was symbolised by subprime lending. However, this circular credit structure was subject to two opposing magnifying effects from the beginning. On the one hand, with the supposed increase in the capital base, easy expansion in credit through many layers of leverage became possible. On the other, the capital base itself became increasingly vulnerable due to the magnifying effect of each defaulted loan, as each loan was linked or correlated with the asset base of several other shadow bankers in whose asset structure those securitised loans had entered. This “double magnification” largely accounts for the fragile circular credit structure on the supply side. To put it differently, continuous innovations in credit instruments rapidly raised leverage while increasing the number of layers on the capital base, whereas the increase in the number of layers raised both the proportion of non-performing loans and reduced the capital base in a magnified way in case of each default through its “correlation effect” on the shadow banking system as a whole.

These ideas can be made more precise through a simple formal model capturing the demand and supply of credit in the shadow banking system described above. Let n = no of layers leveraged on the capital base B. q = proportion of performing loans, 1>q> 0 For reasons explained above, q = q(n), q’(n)< 0. ...(1)

The capital base B depends positively on the level of economic activity Y. It also depends on n, but the nature of dependence is more complicated. The variable n depends on financial innovations, and could be looked upon as an index of the degree of quantity rationing of credit, that is, a higher n means weaker quantity credit rationing of credit. The typical index of price rationing of credit is the interest rate i which is realistically assumed to be at its minimum value, and is left out from the model for the time being for simplicity. Up to some threshold value of n, more assets might be created through securitisation to augment the capital base so that B increases with n, but beyond that threshold value, a further increase in n through high risk securitisation makes the effect on capital base negative. Thus we postulate a credit supply function, S = n.q.B(Y,n), BY >0, B >0 or <0 depending on whether n is

n

below or above the threshold value. ...(2)

The demand for a loan depends positively on both the level of economic activity and the ease with which credit is made available, that is D = D(Y, n), DY > 0 and D >0. ...(3)

n

With the interest rate assumed to be given at some minimum value (analogous to the Keynesian liquidity trap), in the credit market quantity rationing takes over. Any excess demand is attempted to be met by increasing leverage of credit layers n, that is (dn/dt) = a, [D(Y, n) – nqB(Y, n)], a.>0. ...(4)

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For any given Y which allows us to focus exclusively on the credit market, the stability of the adjustment equation (4) requires. K = D– qB – nB(dq/dn) – nqB=D – qB(1+ε) – nqB<0,

n nnn

ε = (n/q)(dq/dn) ...(5)

In other words, stability requires that the stimulation to supply is greater than that to demand as a result of an increase in leverage n, as measured by the slopes of the demand and the supply curves of credit.

From (5) it is clear, if the negative elasticity of q with respect to n, exceeds unity in absolute value, i e, ε <-1, and leverage is sufficiently high to exceed the threshold value to make B<0, the

n

stability of the credit market is sufficiently violated. (The necessary and sufficient condition for violation of stability is less stringent and not discussed here.) In other words, this means, with an already over-extended leverage in the credit market through various innovative credit instruments in place, it is no longer possible for the credit market to stabilise on its own.

Injection of funds by the government would be needed to satisfy stability condition (5). The higher the leverage the greater the volume of funds needed for injection. Assuming injection is proportional to supply leverage for simplicity (other assumptions complicating the algebra are possible without altering the results qualitatively), this would be simply an additive term b sufficiently large to the slope of supply of credit to stabilise the system, that is K = D-qB(1+ε)-nqB-b <0, b>0. ...(6)

nn

The impact on the real economy of stabilising an unstable credit market through injecting funds only to the financial market can be studied through standard comparative static exercise.

Totally differentiating the equilibrium condition of demand equals supply of credit and rearranging terms, (dY/dn) = K/(nqBY-DY), where K<0 by the satisfaction of stability condition (6) with injection of funds. ...(7)

Consequently from (7) the impact of higher n, which may be interpreted as less stringent quantity rationing of credit, would be positive on the level of economic activity Y only if the denominator on the right hand side of (7) is negative. And this requires that in response to an increase in income Y, the demand for credit by households and firms increases more than the supply of credit. The weakness of a policy of only injecting funds into the financial system is implied in this condition. Because the demand for credit by both firms and households may not be stimulated sufficiently in situations where the economic outlook is grim and uncertain due to heavy indebtedness and the fear of unemployment.

Thus, the financial system may be stable and flush with liquidity through injection, but in the absence of sufficient demand for liquidity from the real economy, the depressive economic conditions may continue. This seems to be a real danger of the policies being pursued so far, because governments still refuse to go in for a Keynesian strategy of direct massive public spending for employment and income generation, not routed through making the financial system more liquid. The politics of trying to save capitalism by saving only the financial capitalists may well turn out to be the last twist of the knife from free market fundamentalism to pave the way for a deeper and lasting recession.