Financial Market Crisis 2008

A Review of the Causes of the Collapse of Global Financial Markets in 2008, its effects and appropriate countermeasures

An Article in the Compendium of Market-Based Social-Ecological Economics

Key issues in view of the neoliberal crisis:
How can we guarantee employment and fair income?
How can we protect the environment effectively?
How should we shape the economic globalization?
What should the economic sciences contribute?
What must be the vital tasks of economic policy?
How can we legitimize economic policy democratically?

Click here for the list of all articles: Compendium
Click here for the German language version: Finanzmarktkrise 2008

Table of Contents

  1. Overview
  2. Review of the Deregulation of the Financial Markets
  3. Speculative Transactions Instead of Real Economic Services
  4. The Economic Hegemony of the USA
  5. The Specific Causes of the Financial Market Crisis 2008
  6. The Effects of the Financial Market Crisis 2008
  7. The Countermeasures of the German Federal Government
  8. The G-20 Summits
  9. What Needs to Be Done?
    > Short-Term Stabilization of the Financial Markets
    > Short-Term Economic Measures
    > Medium-Term Measures for the Financial Sector
    > Long-Term Measures for the Financial and Real Economy

1. Overview

Finanzmarktkrise2008-01A review of the financial market crisis 2008 and its causes can sharpen the perception as to the constant dangers emanating from unleashed financial markets. In addition, the review gives reason to demonstrate measures that would rule out a repetition of the crisis and end its negative effects that have persisted to this day.

In 2008, the turn of banks and financial institutions to engage in purely speculative transactions at the expense of their original beneficial function for the real economy has led to the greatest financial market crisis since the 1930s. Ultimately the world plunged into a macroeconomic recession with devastating social and ecological consequences, the extent of which cannot be estimated even after more than a decade. The effects of the crisis are lasting and have therefore also contributed significantly to the sovereign debt crisis that took its course in 2010. Since then, the neoliberal economic system has been in a permanent crisis. Nevertheless, the countermeasures taken so far are inadequate because the responsible politicians are not able to break free from the clutches of globally active profiteers of the system. This will only change if the central cause of the crisis will be tackled, which lies in the still unchecked deregulation and globalization of the markets combined with a democratically not legitimized centralization of economic policy powers and decisions at the World Trade Organisation and the European Union – caused by a reckless surrender of power by national parliaments and governments (see also the article World Trade Organization (WTO).

2. Review of the Deregulation of the Financial Markets

The deregulation of national financial markets began in the early 1970s with the failure of the post-war order (the Bretton Woods System (English)), when the USA attempted to pass on its debts from the Vietnam War to its trading partners by means of an expansive monetary policy. The conflict culminated in a trade policy vacuum, as a result of which exchange rates were unlocked, the solid rules of the Bretton Woods Agreement were softened, and until the beginning of the 1990s, controls on international capital movements were dismantled by all OECD countries. This development was accelerated by the Big Bang triggered by the British Prime Minister Margaret Thatcher in October 1986, which abruptly lifted regulation in the London financial center, followed by international competition for the fastest reduction in regulatory standards.

Open global financial markets were emerging, which allowed global financial transactions and financial speculation and led to the standardization of financial products. The open markets were also suitable for foreign direct investments, which were initially limited to financial capital but were later extended to real capital. Since products and transactions of financial markets could be standardized with relatively little effort, global financial markets took the lead in the subsequent deregulation and globalization of goods and services markets. Under the umbrella of the World Trade Organization (WTO), founded in 1995, deregulation was continued with the General Agreement on Trade in Services (GATS) to grant banks, financial institutions and other service providers worldwide freedom of establishment and business activity – as far as possible independent of national regulation. This process is still ongoing and being driven forward by the WTO, against much opposition.

3. Speculative Transactions Instead of Real Economic Services

FinancialCrisisPNG01The standardization of financial markets began with stock trading. National stock exchanges were networked, prices and fees were converging, trading was made possible around the clock, and a large amount of information was available to private and institutional players. The declining influence of national regulations opened up new opportunities for purely speculative transactions, so that by the turn of the millennium the globalized financial economy had recorded a volume of speculation-based business activity that far exceeded its serving function for the real economy.

On the stock market, the concentration process among banks and financial institutions ensured that institutional players could deliberately influence share prices with huge transaction volumes and tendentious news and use them for quick profit-taking – usually to the detriment of small investors. This speculation was further encouraged by remuneration systems specially tailored to the management of public limited companies, usually stock option plans, which tempted this group of people to announce or implement measures on a regular basis that drove up their own company’s share price in the short term in order to collect the difference in price based on a virtual block of shares as a bonus without personal risk.

In addition, with the so-called high frequency trading, a tendency arose to have large-volume transactions carried out fully automatically by computer systems to take advantage of even the smallest price movements within milliseconds. The enormous global liquidity that was thus supplied to the markets brought two decisive advantages for all speculators: it guaranteed a constant up and down of prices as well as the fastest execution of buy and sell orders. So short-term speculation became the hallmark of the globalized stock market. Long-term commitments, where investors could once benefit from the rise in fundamentals and dividends, became a game of vabanque.

At the same time, forward transactions, which had originally been developed to hedge price risks (weather, interest rates, exchange rates) in trade with agricultural products and commodities, were stripped of their real economic function and offered as bets on the development of interest rates, exchange rates, securities, indices and fictitious bonds. Because the new types of financial instruments were derived from conventional investments, they have been referred to as derivatives ever since. In addition, so-called short sales were permitted in stock trading, allowing institutional players (see above) to increase their transaction volumes at will by means of temporarily loaned share packages and thus to be able to influence prices even more strongly in their favor.

To ensure that the business of speculation continues to grow, the financial industry has since employed legions of experts and mathematicians who are constantly developing new and increasingly opaque derivative instruments. This has resulted in a cascade of derivatives in which risks are passed on from one level to the next under the misguided assumption that the risks are thereby eliminated or controllable. (As will be shown below, one of these instruments played the main role in the financial market crisis 2008). Finally, under the now euphemistic term »investment banking«, banks shifted their business focus more and more towards speculative engagements and neglected their original mission of providing local companies with loans. Ever since, even companies in the real economy have increasingly invested their profits in financial products and neglected their investments in physical capital.

4. The Economic Hegemony of the USA

The world financial and economic crises of the 20th and 21st centuries can only be understood in the context of the importance of the US dollar and the special role of the US in international trade.
The gateway for understanding this is

  1. the size and uniformity of the US domestic market and the resulting function of the US dollar as a reserve currency,
  2. the large volume of US domestic demand, including a disproportionately high demand for raw materials, both due to the consumption habits of the US society,
  3. the corresponding debt financing or foreign debt of the USA required and the resulting increase at foreign central banks in US dollar reserves and US debt securities,
  4. the power position of the USA in supranational bodies (underpinned by military power), and finally
  5. the worldwide dominance of the English language.

Even during the negotiations on the Bretton Woods Agreement in 1944, the high demand for raw materials in the US economy and the cross-border expansion of the US real and financial sectors were the main driving forces behind post-war world trade and the subsequent deregulation of national markets. Since the opening of the markets at the beginning of the 1970s, the consumption needs of US citizens have been driving up the US import volume, the trade deficit and subsequently the budget deficit of the country, ousting domestic producers and jobs and causing extreme social inequality. This development created a risky mutual dependency between the US as an overimporting country and many of its trading partners specializing accordingly in export production – above all China and Germany. The dependencies were reinforced by the acquisition of US assets such as government bonds, corporate holdings and real estate by foreign creditors, again with China in the lead. At the same time, the surpluses of the exporting countries were increasing the demand for speculative financial assets.

Although critical economists have called again and again for a disentanglement of the risky dependencies, this subject has never been on the global agenda. If it were to be tackled, it could only be achieved in a long-term process controlled by national economic policies, which would necessitate a return to functioning domestic cycles as a foundation for regulated international trade. A disentanglement is also conceivable unilaterally by individual national economies, and is, under the increasing social pressure, even more likely than a broad supranational or even global initiative. As long as the dependencies exist, the world economy will be in a stranglehold of the US dollar exchange rate, US interest rates, US stock prices and the prices of US assets. Every recession of the US economy is therefore inevitably followed by a global recession. The macroeconomic consequences of the 2008 financial market crisis are further evidence of this inevitability.

5. The Specific Causes of the Financial Market Crisis 2008

The 2008 financial market crisis was a crisis caused by massive speculation with all its typical characteristics and effects: Already in the late 1990s, US banks began to bundle (securitize) mortgages into tradable securities, mainly into so-called mortgage backed securities (MBS. Many of the home buyers and borrowers were low-income and wealthless individuals, so that MBS should have been classified as second-class (subprime) at large. The risk was nevertheless considered low because the US Federal Reserve System, supported by the government, pursued a policy of low interest rates (cheap money), also to encourage private property purchases. Against this background, the rating agencies classified the MBS as first-class and turned a blind eye to the risks that were actually obvious because of the long maturities of the mortgages. Global trading in the securities started, and prices were rising rapidly due to the good rating, making the securities a sought-after speculative investment.

Banks began to set up special purpose entities to which they sold the securities in order not to exceed their equity ratios when prices rose, and to outsource the risk. However, the systemic risk was further increased by the special purpose entities which refinanced themselves on the money market on a short-term basis to increase their profits. In other words, the securities, which had a long maturity, served as collateral for inexpensive short-term loans. This led to a dangerous, so-called maturity transformation, which violated the principle of maturity congruent refinancing. Hedge funds also acquired the securities and even insurance companies entered the business and offered investors policies against capital loss. A speculation bubble emerged, the virtual value of which grew to a multiple of the risky fundamental values (the mortgages).

2005 marked the beginning of an economic downturn with unemployment in the USA, and in 2006 the US Federal Reserve had to raise the key interest rate to as much as 5.25% to counteract inflation. As a result, many home buyers could no longer meet their interest payments, a wave of foreclosures began, resulting in falling property prices. As the crisis was recognized in 2007, MBS papers were barely covered by the collapsed fundamental value of real estate, but could no longer be traded because, given the risks, no buyers could be found. The obligations entered into to refinance the securities could no longer be met and no lenders could be found for new refinancing. In 2008 the MBS market finally collapsed completely.

6. The Effects of the Financial Market Crisis 2008

The crisis took its course: banks that had invested large amounts in the securities or certificates of other affected institutions became insolvent. Interbank trade also collapsed, payment transactions faltered, companies were no longer able to obtain loans and private individuals were worried about their savings. The impending economic downturn led to panic selling on stock markets around the world, culminating in a phase of hope and fear with correspondingly strong price fluctuations. Real economic production and services as well as trade and purchasing power declined simultaneously, entangled in a vicious circle, prices on the raw materials markets plummeted, exchange rates went crazy, a first wave of short-time work and layoffs began and pushed national economies worldwide into a recession with deflationary tendency.

Among the winners of the crisis were only the few players who had speculated on falling prices or were able to use price fluctuations caused by the crisis for profit-taking. Once again, it was institutional investors who took advantage of these fluctuations or even brought them about by short selling – as could be seen in particular from the performance of the VW share price at that time. Those who had sold their securities in time had at least escaped without losses. But the winners also included those who had invested their money in savings deposits such as time deposits and refrained from any speculation. Among the losers and existentially affected by the crisis were not only the low-income US citizens who had purchased real estate at low interest rates and without equity capital, but also the banks and financial institutions mentioned above and the small savers who had been talked into buying supposedly safe, high-interest securities from banks. Those who were already rich before the crisis were now at best a little less rich.

The financial market crisis 2008 demonstrated to the world how existentially important a functioning financial system is for the real economy, especially with regard to the available credit volume and payment transactions. On the other hand, the crisis made it abundantly clear how nonsensical and irresponsible it is for the financial sector to neglect and jeopardize its exclusively beneficial function for the real economy and, partly with criminal energy, to shift its business focus to the invention and operation of financial snowball systems. But the crisis also had its good side: illusions of quick wealth were destroyed and brought people back to the basis of real values. Whether the learning effect was sufficient to combat the systemic causes of the crisis in the long term, however, must be doubted in view of the political reactions that can still be observed today.

7. The Countermeasures of the German Federal Government

The Federal Government adopted a series of measures to stabilize the financial markets, largely covered by the Financial Market Stabilization Act (FMStG) passed in October 2008. The overriding aim was to protect jobs, economic growth and the social market economy (which one?). In particular, confidence in the financial markets with regard to interbank trade (mutual loans) was to be established on a permanent basis, thereby also securing savings deposits. Direct state aid to banks and financial institutions was only granted subject to conditions such as salary caps and waiver of dividends.

Specifically, the security of private savings deposits was guaranteed by the Federal Government (without legal force to date). Banks and insurance companies were obliged to adopt stricter assessment and accounting rules. The Federal Government assumed guarantees for the refinancing of institutions up to a maximum total amount of EUR 400 billion and, as a precautionary measure, entered 5 % of this amount (EUR 20 billion) in the federal budget as a potential loss. A further EUR 80 billion was made available for recapitalization (equity participation) and the takeover of problem assets. These EUR 80 billion plus the aforementioned EUR 20 billion were transferred to a Financial Market Stabilization Fund (FMS) by way of borrowing (new debt) and managed there. Interest payments which institutions had to make for guarantees, equity investments and takeovers by the Federal Government were negotiated on a case-by-case basis.

Worse than the losses to be socialized via the budget was the fact that the Federal Government clearly failed to recognize the cause of the crisis attributable to the purely speculative transactions of the so-called investment banking, and therefore took no precautions to put a stop to these transactions. To this day, all the Government’s measures are still aimed at ensuring the functioning of the deregulated global financial markets and all its business areas. And, to stabilize the markets, it has always relied and continues to rely primarily on the insight and reversal of the culpably entangled players instead of safeguarding the money cycle through state regulation. In the meantime, the path has been set to use the deregulation of the markets as a miracle cure for the devastations caused by this very deregulation. Even the Federal Financial Supervisory Authority (BaFin), which is bound by the instructions of the Minister of Finance and which was accused of failing in the crisis, remains a neoliberally calibrated institution.

The irony of the financial market crisis is that it has initiated a process of selection and concentration among financial institutions, which has ultimately concentrated the power and capital of the institutions in an even smaller number of hands and will thus increase the risk of future abuse. The financial market crisis of 2008 was, as mentioned above, also a major driver of the sovereign debt crisis that began in 2010. The phenomenon that one crisis feeds the next will persist if the power and capital of the institutions is not split up by means of decentralization.

8. The G-20 Summits

In November 2008, the G-20 Leaders Summit on Financial Markets and the World Economy took place in Washington, D.C. The aim was to implement jointly agreed measures in the short and medium term to prevent a repetition of the financial market crisis and put the world economy back on a growth path.

The consultations during the meeting initially moved between opponents and supporters of further liberalization of world trade: British Prime Minister Gordon Brown made a commitment to neoliberal globalization and neoliberal free trade, while French President Nicolas Sarkozy advocated a return to fixed exchange rates. German Chancellor Angelika Merkel supported the British view by arguing for an immediate revival of the Doha Round of the World Trade Organisation (WTO) to further deregulate and liberalize world trade.

The final declaration of the meeting, however, suggested agreement and concluded with a commitment to the principles of free markets. On this basis, rating agencies and hedge funds were to be more strongly regulated and monitored, complex financial products uniformly assessed, banks’ equity ratios increased, unfair competition from tax havens prevented, consumers better protected and the International Monetary Fund (IMF) strengthened. The WTO was indirectly confirmed in its decision to continue its neoliberal course in the Doha Round.

At the Berlin Summit in February 2009 in preparation for the G-20 follow-up meeting in April 2009, the final declaration stated that a breakthrough in the revitalization of the Doha Round had top priority »to protect the world economy from protectionism«. Thus, the future direction was for the first time outlined with the neoliberal combat term »protectionism«. A term that is always used in a discrediting way when countries unilaterally or bilaterally try to undermine the multilateralist dictates of the WTO to protect their citizens and their environment from the worst consequences of predatory competition in deregulated markets. For further details, I recommend the article Protection and Protectionism.

At the G-20 Summit in Pittsburgh in September 2009, the above-mentioned declarations of intent were finally renewed without adopting any concrete measures. In the meantime, it could be observed that the protagonists of the global financial economy exerted great pressure on politicians, especially in the financial centres of London and New York, and returned unhindered to the old business practices. This development continues unabated.

However, the different views within the G-20 on foreign trade principles as well as the different national interests remained. In this respect, there was no chance from the outset to address or even eliminate the central inherent contradiction of the neoliberal economic and financial system. This contradiction existed and exists between the principle of free competition between countries and corporations in open global markets – based on freely forming exchange rates and competition in dollar prices – and the illusory claim that this unregulated competition, in which different national interests regularly get in each other’s way, could be harmoniously designed for the benefit of the world community by supranational institutions such as the WTO and the IMF.

The contradiction cannot be resolved by global institutions, because it is systemic in nature. In addition, the asymmetric power relations among the 154 member countries of the WTO stand in the way of resolving the contradiction. But above all the fact that the different traditions and productivity levels of the member countries fundamentally rule out mutual prosperity gains in dollar-based trade, i.e. without agreed bilateral exchange rates that neutralize the productivity gaps. It is therefore a waste of time to rely on a sustainable consensus in the WTO. As long as the WTO with its systemic contradiction remains in place, the causes for the worldwide social and ecological devastations will remain untouched.

Changes for the better can only come from individual pioneer countries that run counter to the neoliberal mainstream in the WTO and set an example that others can follow.

9. What Needs to Be Done?

FinancialCrisisPNG02

The extent of the financial market crisis 2008 must not distract from the systemic permanent crisis caused by the deregulation of all markets, thus also the goods, services and labor markets. The permanent crisis has been responsible for worldwide unemployment, unequal distribution, poverty and environmental degradation since the 1990s. Not only must the financial economy be returned to its locally and regionally beneficial function, but the real economy must also be rebuilt nationwide after years of depletion to create a foundation of local and regional economic cycles that is equally indispensable for national economic strength as well as for European and global exchange.

The aim is to achieve democratic market economy conditions. This means, the process of centralizing economic policy powers in the EU and WTO must be reversed by (re-)assigning these powers on a subsidiary basis, starting at the local level, and by (re-)structuring economic enterprises accordingly from the bottom up. Subsidiary structures are suitable like no other structural order for employing the production factors labor and natural resources efficiently in the spirit of social justice. That is, to aim for performance-related equal distribution and ecological sustainability while subordinating the efficiency (the return on investment) of the factor capital to these aims. In other words: the factor capital must unconditionally be put at the service of labor and natural resources. Only in this way can a democratically legitimized market economy be created that does not entail capitalist imbalances and distortions (for more details see the article Economic Subsidiarity).

Short-Term Stabilization of the Financial Markets

  1. Globally operating or entangled banks must be temporarily placed under state control in order to secure deposits, grant loans and ensure payment transactions.
  2. To be prohibited: short sales on the stock market; forward transactions and derivatives that do not serve to hedge the risks of transactions in the real economy; the bundling of securities for the purpose of risk diversification; special-purpose entities; hedge funds; rating agencies; and payment transactions with tax havens, except for the repatriation of flight capital.

Short-Term Economic Measures

  1. All economic activities as well as research and development programs that pursue future-oriented objectives must be subsidized or receive tax benefits. The most important objectives are: energy efficiency, renewable energies, resource efficiency (substitution or reuse of non-renewable resources and sustainable use of renewable resources), waste and emission avoidance, technologies for decentralized application, organic farming, and child and elderly care.
  2. All private income and assets are to be subjected to linearly progressive taxation, open at the top. Taxation is to be adjusted annually to inflation so that no cold progression occurs.
  3. All low incomes are to be topped up by state transfer payments in such a way that every citizen has an income of at least 125 percent of the subsistence minimum.
  4. All social insurance schemes for old age, illness, nursing care and unemployment must be converted to the principle of »solidarity-based compulsory citizens’ insurance scheme«. Meaning that all citizens, without exception, must pay a fixed percentage of their total income into the insurance schemes, but only receive uniform benefits in the event of an insured event.

Medium-Term Measures for the Financial Sector

  1. All banks and savings banks are to be decentralized as far as necessary and returned to their original business: namely to invest savings deposits locally, regionally and nationally, to grant loans to companies and both private and public households and to engage in regulated securities trading.
  2. Institutions temporarily under state control are to be privatized again as part of their decentralization.
  3. Cross-border payments should be placed under national control to enforce the principle of local social responsibility of capital and property and to prevent capital and tax evasion.

Long-Term Measures for the Financial and Real Economy

  1. Conversion of securities trading (including stock trading) to long holding periods of securities in order to exclude short-term speculation.
  2. withdrawal from the obligations of the World Trade Organisation (WTO) and the International Monetary Fund (IMF). Transition to bilateral and manageable multilateral agreements, also with regard to international cooperation and development aid.
  3. Decentralization (subsidiarization) of economic policy powers and of economic structures for the purpose of economic diversity, decentralized responsibility and democratic legitimacy.
  4. Trade agreements on fixed exchange rates, which neutralize the average price differential (and thus indirectly the average productivity gap) between trading partners, and which allow mutually beneficial foreign trade and international competition as well as balance of trade, current account and payments, and which eliminate foreign exchange speculation.
  5. Active participation in supranational and global bodies to achieve consensus on future-oriented normative guidelines for bilateral and multilateral economic relations, cooperation and development aid.

In addition I recommend the articles EU: Federal Superstate or Confederation, Democracy and European Integration, Ten Imperatives to Secure Our Future, and also Currency War and Exchange Rate.

Click here for the German language version: Finanzmarktkrise 2008.

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