The present situation "is the crisis of a system which moved away from the fundamental values of capitalism", declared Nicolas Sarkozy in Toulon. The XXth century illustrates, however, that there is no capitalism without crises.
M.B. Baudet, Ph. Mesmer, A. Reverchon, A. de Tricornot
[Translation and comments in brackets A. Cabannes]
Le Monde, 12 & 13 October 2008
Over the last hundred years, capitalism took over step by step the whole planet. Relying on individual entreprise and private property, it made possible an unprecedented growth. Yet the history of the XXth century shows that it is vain to expect from this to live in a world of continuous economic progress without bumps. Recessions and economic crises are consubstantial to the system.
Causes: While the American economy was growing fast (construction of railways, development of electric networks, etc.), it became noticeably unstable after the San Francisco earthquake of April 1906, which lead to the transfer of large amounts of capital from New York to the West coast to help with the reconstruction.
The situation became tense in July: the continuous rise of copper prices (+60% from 1903 to 1906), the raw material indispensable to electrification, was causing a decrease in the profitability of railways and tramways which, as consequence, began to reduce their orders. Copper prices fell, inventories went up. In September, the entire copper industry was concerned. Banks, which were financing the cartels and maintaining close ties with them, turned the credit faucet off. The panic was amplified, on Monday October 14, by a "corner" on copper (a tentative purchase, by a few operators, of all the copper available in order to make prices skyrocket and pocket huge profits), which failed two days later. During this black week of October, overnight interest rates climbed to 125% (on a yearly basis).
Consequences: the distrust propagated to all the banks. Households and individuals went to the bank windows to withdraw their money. The financial crisis turned into a recession, which affected primarily railways, and metal and electric industries. Bankruptcies multiplied. The rate of unemployment of blue collar workers in the state of New York soared to more than 35%, while salaries decreased by 15% on average, explains Philippe Gilles, author of L'Histoire des crises et des cycles économiques, Armand Colin, 2004. Europe too was contaminated, mostly Germany (which dismantled the cartel of cast-iron of Düsseldorf) and Great-Britain (shipyards and textile industry).
Measures: The American Treasury stepped in to bail banks out. On 11 November 1907, the total amount of help it had given had reached 230 million dollars. Rescheduling of payments and guarantees of deposits were also applied. But it is the intervention of J.P. Morgan which proved decisive. The American financial tycoon set up a banking pool (together with John Rockefeller and others) which injected millions of dollars in the economy. The magnate identified the ailing banks and sent his lieutenants to bail them out. Trust came back.
The 1907 crisis convinced the US authorities that its banking system was too weak, too close to the trusts, and therefore controlled only by a handful of industrialists and financiers. In 1908, the Congress set up the National Monetary Commission in charge of studying and proposing the necessary reforms. The commission work lead to the creation of the US central bank, the birth of which was officialized on 23 December 1913 by the "Federal Reserve Act".
Causes: In the crisis of 2007-2008, the banking system collapse, caused by the "rotten" financial assets linked to the subprimes, came before the slump of the stock markets. In 1929, the sequence went the other way around. The speculative bubble which appeared in June 1928 did not concern mortgage loans but shares of stock of the firms listed on Wall Street (the New York Stock Exchange) which seemed promised to an indefinite growth: 920 million shares changed hands in 1928, compared to 577 million the preceding year.
But from the first signs of a cyclical downturn in the Summer of 1929, the sale of securities by a few large investors, who wanted to cash in their capital gains when it was still time, triggered a gushing cascade of sales on the market: 6 million of shares sold the 24th, 9 million the 28th, 16 million the 29th. The phenomenon was aggravated by a "financial innovation" comparable to the securitization of mortgage loans of the late XXth century: the "call loans" (overnight loans) which enable anyone to buy stocks with a comparatively small cash outlay, the difference with the real price being covered by a broker in the form of a bank loan ["safe because the market values of portfolios of stocks were going up anyway"].
Small individual investors, but also brokers, ruined by the downfall of prices, were incapable of repaying their loans, and caused the bankruptcy of some banks, which in turn fuelled the panic of depositors, thereby causing the bankruptcies of other financial institutions even though those were less exposed (4 300 between 1929 and 1931).
Consequences: the banking crisis propagated throughout the international financial system, debtor to American banks [since WWI], and reached the real economy. The drying up of credit prevents the firms from investing and the ruin of the small investors shrinks their client base, prices tumble, unemployment rises, international trade decreases. According to the historian Pierre Bezbakh, professor at Paris-Dauphine University, the industrial production index (set at 100 in 1913) goes from 153 in 1929 to 108 in 1932. In 1933, 12.8 million people are unemployed in the United States, 6 million in Germany, 4 million in Great-Britain. Between 1929 and 1933, international commerce shrinks by 69% in value, and 25% in real terms.
Measures: Elected in 1932, the Democratic president Franklin Roosevelt launches in 1933 the New Deal, a series of measures including a devaluation of the dollar (-59% to improve the US trade competitiveness), a guarantee of bank deposits (to save banks from bankruptcy), a rescheduling on bank loan repayments (to spur consumption), quotas on agricultural and industrial productions (to stop the prices downfall), and large public works (to lower unemployment [and, according to Keynes "multiplier effect", to restart the economy]). Secondly, in 1935, he created a social security system and protected the rights of trade-unions. But it is only in 1940, with the growth of the arms industries, and the United States entering the conflict in 1941, that unemployment and poverty began to subside.
Most other large countries also devaluated their money (the pound sterling in 1931, the franc in 1936 [which had already been devalued by 80% in 1928]), applied a policy of tarifs and quotas, launch public works, and set up system of social protection. The primary aims were to protect national economies. But those conducted by Germany, Italy and Japan, would end up in an armed conflict between totalitarian regimes and democracies.
Causes: Beginning in 1986 and until the 1990s, the American Savings & Loan sector went through a turmoil caused by the real estate crisis. The downturn of the market revealed the frailty of these institutions, small and often badly managed, already weakened by the deregulation of the financial sector. Alongside with the S&L, the private bank system was also under pressure from the difficulties of the real estate and the beginnings of deregulation, but from the effects of the Latin American crisis and that of the "junk bonds" (bonds with high return and high risk of failure).
Consequences: Between 1989 and 1992, 650 local S&Ls were forced to close down. From 4000 before the crisis, their number now is less 1500. The most severe banking crisis that United States had known since WWII was overcome in a few years. This recovery was used as a showcase, even though its cost was criticized. However, the lessons from the crisis (excess of deregulation, risky financial innovations, real estate bubble) were not learned by the banking system.
Measures: The authorities created a financial structure to bail out the S&Ls, the Resolution Trust Corp. (RTC), which took over bankrupt S&Ls and thus avoided a crisis of public confidence. This structure is noted for having organized auctions of bad loans [a loan is an asset of a bank, the value of which depends on the timeliness of payments by the borrower; if the borrower defaults on the payment schedule, the market value of the loan goes down], sometimes bought by "vulture funds" at 10% of their theoretical value. "The RTC recorded about $150 billion of losses on $500 billion of assets it was in charge of liquidating. The final cost, therefore, was finally about 1/3 of the total sums concerned", explains Bruno Cavalier, chief economist at the stockbrokerage firm Oddo.
At the same time, the Federal Deposit Insurance Corporation (FDIC [created by Roosevelt]), the institution in charge of guaranteeing bank deposits, was mobilised to help commercial banks: it closed or helped more than 900 private financial firms between 1986 and 1991. Backed by a $70 billion line of credit from the Treasury, the FDIC set up "relay banks", in charge of carrying temporarily the ailing financial institutions, before they were either resold or liquidated.
The Federal Reserve, which is the American central bank, also applied a policy of low interest rates at the beginning of the 1990s, to help the banking sector rebuild its strength. "The final bill for the American S&Ls salvage operation was only known in 2001. The raw cost to the American taxpayer turned out to be 3.6% of the gross domestic product (GDP), but the net cost amounted only to 2%, that is $124 billion", explains Jean-Pierre Petit, head of economic research and strategy at Exane-BNP Paribas.
Causes: At the end of 1989, the Nikkei index reached 38 915 points, three times the level of 1986. Japan lives through the paroxysm of a real estate bubble, fed by a generalized laissez-faire, primarily that of the Minister of Finance and his colleague's at the Ministry for International Trade and Industry (the famous MITI), who lower the interest rate to 2.5% and apply an accommodating monetary policy. Firms and individuals take advantage of this credit easiness to accumulate, in Japan as well as abroad, assets which quickly become overvalued.
In 1990, a new international environment, in particular the first Gulf war, and the rise of the interest rate to 4.75% cause the bubble to burst. Banks find themselves with bad loans the amount of which reaches 9000 billion yens (65.7 billion euros) en 1995. Several of them go bust. The real economy is affected, to start with the construction sector.
Consequences: The number of banks went from 605 in 1991 to 411 in 2006; the number of large ones, during the same time, going from 28 to 8. The average yearly growth, from 1990 to 2002, does not exceed 1.6%, compared to 3.3% in the 80's. Unemployment jumps from 2% to 5.5%, precarious work contracts increase, real estate prices tumble, deflation sets in Japan.
The Nikkei has not reached back its level of nineteen years ago. On October 9th, 2008, it closed at 8276 points.
Measures: To get out of the crisis, the government launched 12 twelve successive plans to boost the economy, for a total of 1027 billion euros, a policy still weighing on public accounts, the debt of which is 180% the size of the GDP. Even though the plans began in 1992, it is not before 1998 that the government took really drastic measures, devoting 20% of the GDP to the salvage of banks. About one third of this sum was used to recapitalize - and temporarily nationalize - two banks (LTCB and JCB), one third to guarantee the deposits in bankrupt banks, and 40% to inject capital in non-nationalized banks. From 1999 to 2005, price declined and growth was nil. Interest rates remained equal to zero until March 2006, when the central bank raised them to... 0.25%. Besides, from 2001 until 2006, the bank undertook massive injections of capital, deemed at the time unorthodox by the financial community.
Causes: At the outset of the 1990's, the burst of the housing bubble put in jeopardy numerous European financial institutions. The main Swedish banks, including the SEB, are threatened. In Spain, the fourth largest bank, the Banco Español de Credito (Banesto), is virtually bankrupt; in France, the Crédit Lyonnais, the Comptoir des entrepreneurs, the Crédit foncier and the insurance company GAN have difficulties. The four largest British banks (Barclay's, National Westminster, Midland and Lloyds), confronted with the deregulation of the financial sector, see their results collapse.
Consequences:
In Sweden, the banking sector recovers its profitability only in 1994, at the cost of a complete restructuration. It reaches back the level of credit it had before the crisis, only in 2002.
In Spain, the banking sector emerges from the crisis completely transformed: Santander, the seventh Spanish bank in 1993, buys Banesto, the number 4, before merging in 1999 with the number 3, Banco Central Hispano (BCH).
In France, the demise of banks causes massive job losses. Later on nationalized, these firms eventually are acquired by their competitors at prices way below their pre-crisis value: the Crédit Lyonnais is bought by Crédit Agricole; the GAN by Groupama; the Comptoir des entrepreneurs and the Crédit foncier, after many tribulations, by the Caisses d'épargne.
In the United Kingdom, banks lay off tens of thousands of people. In 1992, the Midland Bank is bought out by HSBC. In 1995, Lloyds Bank merges with its competitor TSB; In 1999, Natwest is absorbed by the Royal Bank of Scotland.
Measures:
In Sweden, at first the government helps banks one by one with no grand plan. In September 1992, faced with the aggravation of the crisis, it guarantees all the credits in the assets of banks, but requires as a counterpart a percentage of their capital, and thus finds itself at the helm of several banks. It creates in 1993 the agency Securum, in charge of the doubtful loans. The cost of the plan is nearly 4% of the GDP. But in 1997, the sale of the assets which the state had taken in charge reduced this cost by half, and today they more than compensated their cost.
In France, to avoid that the difficulties of the publicly controlled institutions contaminate the banking system, the State sets aside the bad real estate [and other] assets into "defeasance structures": the Consortium de réalisation (CDR) for the Crédit Lyonnais, the Société de gestion de garanties et de participations (SGGP) for the GAN, and the Nouvelle société de réalisation de défaisance (NSRD) for the Comptoir des entrepreneurs. As regards the Crédit foncier, it is backed by the Caisse des dépôts. The sale of the bad assets allowed the State to reduce the final bill of the crisis, but it remained around 21.3 billion euros (140 billion French Francs), estimated the Cour des comptes in 2000.
In Spain, Banesto was put into the equivalent of receivership the 28th of December 1993. The Bank of Spain dismissed the board of directors and its president, Mario Conde. In February 1994, a plan of recapitalisation of 605 billion pesetas (3.8 billion euros), financed mostly by an interbank guaranty fund, in which took part all the main banks and the Bank of Spain, was adopted. The plan included the later sale of the bank, which was achieved in 1994 when Santander bought it.
In the United Kingdom, the Bank of England lowered several times its interest rates, helping banks to refinance themselves more easily and rebuilding their margins;
Causes. The real estate bubble in the United States - prices which doubled between 1997 and 2006 - was not only fuelled by the lowered interest rates, a measure taken to sustain the economic growth, but also by a spectacular increase of the debt of households, the saving rate of which [the percentage of revenues put into savings] has become negative. This increased debt was facilitated by the extreme deregulation of the financial sector, in particular the "subprime mortgages", risky housing loans [that did not meet the standard criteria of lending but were] backed by a mortgage on the house asset [the price of which was going up during the bubble], which represented 13.6% of real estate credit in the United States in 2006. These "exotic" credits had a variable interest rate, but very high - 4% to 5% above normal rates. Thanks to an easy regulatory framework, the borrowers were encouraged by loan brokers to declare false and inflated revenues in order to qualify for the loans. As long as the prices of houses were going up, the bubble grew, and the borrowers were pushed to bring the value of their house as a gage to borrow again. On the lender side, banks exploited to the brim the techniques of "securitization" to rid their balance sheets of these risky loans and resell them to investors, meanwhile disseminating the risks in rather opaque products.
Consequences: At first considered with no risk, these securitized products turned out to be "toxic" [a fad word to mean very bad loans], when the real estate sector went into a downturn. From the Summer of 2007, a vicious circle of bank losses, fears of bankruptcies, and downfall of markets built up, as well as a crisis of confidence between banks, incapable of lending to each other [as they constantly do in the normal course of business], which lead to a credit shrinkage. The crisis caused the burst of the excessive-debt bubble of the American economy - which also concerned other types of credits (consumption, leverage buy outs of firms) -, thus sending the financial institutions into severe difficulties. While the federal government organized the bail out of the investment bank Bear Stern, and of the semi public agencies specialized in refinancing housing loans Fannie Mae and Freddie Mac, or of the insurance company AIG, they let the investment bank Lehman Brothers go broke, and closed Washington Mutual, the sixth largest bank in the United States.
The crisis spilled over to Europe and the emerging countries, the banking institutions of which, that had bought securities issued from the securitizations, found themselves trapped by their own real estate markets downturns, by the collapse of the securitized products, and by the credit freeze. Like the American banks, many banks had to be recapitalized, sovereign funds and Japanese financial institutions becoming on the occasion significant shareholders. The downfall of the stock markets is of historical proportions.
Measures: In the United States, the first spectacular measure, on September 7th 2008, is the injection of $200 billion to maintain above waters the two housing mortgage loan refinancing agencies, Fannie Mae and Freddie Mac. Nine days later, the Federal reserve of the United States takes over 80% of the capital of AIG to prevent it from going bankrupt. But the most important decision is the Paulson plan, named after the American Secretary of State of the Treasury [ex president of Goldman Sachs], of $700 billion, first rejected by the House of Representatives, but then adopted on Friday October 3rd, 2008.
The American example is largely followed in Europe. Island and Great-Britain engaged into nationalizations of their largest banks. Germany recapitalized a part of its financial institutions (nearly 10 billion euros injected in IKB), Belgium is nationalizing Fortis, then, together with France, comes to help Dexia, while Russia extends a $36 billion loan to its private and public banks in needs of liquidities. Paris, through its Prime minister François Fillon, announced on October 8th, the creation of the Société de prise de participation de l'Etat (SPPE) which will enter into the capital of banks running into difficulties, to whatever level is needed.
States pledge to guarantee the deposits of private persons. "I'll not accept that a single depositor lose a single euro", declared on September 25th, French president Nicolas Sarkozy, followed by most European heads of states or governments. On October 7th, the Finance ministers of the European Union agreed to set, for an initial period of at least one year, the minimal threshold of guarantee of deposits to 50 000 euros, compared to 20 000 euros precedingly.
Central banks, since the beginning of the crisis, have multiplied liquidity injections [pure accounting double-entries in their balance sheets, on the asset side as loans, and on the liability side as new hard money reserves for secondary banks] in order to satisfy financing needs of banks. Key feature of their intervention, their common lowering of rates, Wednesday October 8th, by the central banks of Europe and six other countries: Canada, China, the United States, Great-Britain, Sweden and Switzerland.