Home 2011: 3 The economic crisis: What are the main causes?

The economic crisis: What are the main causes?

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Jeyakumar Devaraj observes that the global economy is in trouble as there just isn’t enough demand to attract industrial investment.

Graphic courtesy of stock.xchange

The world economic system is being buffeted by a series of crises, and this in turn has led to economic hardship for millions throughout the world.

In many countries, the people are suffering in silence, but there are increasing signs of protest. Mass protests broke out in Britain because of tuition fee hikes, protests in France because of the raising of the pensionable age, discontent in Spain and Ireland because of wide budgetary cuts that have slashed spending on social services such as health care and welfare, and most recently, popular revolts that have brought down dictatorships in Tunisia and Egypt.

The unfolding economic crisis will very probably continue sending ripples across the world, and these will affect us negatively in Malaysia. We therefore urgently need to understand what is happening and why, so that we can prepare ourselves for the economic trials ahead. Unfortunately the conventional media’s coverage is superficial and often misleading.

Speculation and derivatives

I share the view of many left thinkers that the collapse of the planned economies of the Soviet Union and the Eastern Bloc greatly accelerated the out-flowing of industrial capital to countries with lower costs of production – i.e. lower wages and lower tax rates. Firms that successfully relocated to these low-costs locations, where the costs of labour are as low as a twentieth that of the US and Europe, were able to reap huge profits as they were able to win over the markets of firms that did not make such a shift. As a result these successful firms had a healthy surplus that they wished to invest.

Many of the firms that did not transfer their factories to the cheaper peripheries were forced to downsize and lay-off workers as they were losing market share to the firms that relocated. This and the earlier decision of the ‘successful’ firms which transferred production to lower wages locations resulted in the hollowing-out of the consumer market in the US and Europe. The ‘successful’ firms were then holding excess funds that they wished to invest, but were faced with sluggish growth in demand for consumer goods. So they had to look for other opportunities to invest in and realise profits, and one of the important outlets was the financial sector – the share market, commodity trading (where contracts are made to buy or sell commodities in the future), currency trading where parties buy money in the expectation that the value of that currency will appreciate, or enter into a contract to sell a particular currency at a specified time in the future with the expectation that that currency would actually be lower than the contracted price at that specified time.

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The existence of surplus funds seeking investment opportunities encouraged financial institutions to create strange new financial specie such as ‘derivatives’. Housing loans were packaged together and then this ‘derivative’ was sold to investors who thus gained a right to the income from these loans. So too with insurance policies – these too were grouped together to yield ‘derivatives’ that could be sold to investors. It didn’t end there, as there then developed a market for derivatives much like the stock market where derivatives themselves could be bought and sold. Given the fact that only about 10 per cent of the total price of the derivative needs to be paid on purchase (the remainder to be paid up after 30 days), the phenomenon of “leveraging” became common practice – instead of buying X shares with the fund at one’s disposal, one buys 10X shares in the expectation that one will be able to sell all these shares at a higher price before the 30-day period. Financial activities fuelled by surplus funds with no outlets in manufacturing real goods, began to resemble a casino – and one where great profits could be made in a short span of time. The lure of quick profits (when times were good) led to the creation of “speculative bubbles”.

On brink of collapse

But things began to unravel in 2007. There was a moderate shortage of petroleum in the world market. Manipulation of the market by the big players sent the oil price soaring to more than US US$120 per barrel when the real price – if determined by the laws of supply and demand – should have only been in the region of US$60. This huge hike in petroleum prices impacted on food prices – both because the cost of food production went up (diesel for machines used to plant and harvest foods, and for the transport of food products) and because certain food crops were channelled to the production of bio-diesel.

The poorer people in the US were badly hit by the escalating price of fuel (a crucial expenditure in the winter months) and food. As a consequence they began defaulting on their housing loans in fairly large numbers. The banks had approved these subprime loans on the expectation that the housing bubble would keep expanding. If it did, houses of defaulting house-buyers could be sold off and the bank’s loan outlay recovered. However, mid-2008 saw a situation where a large number of defaulters flooded the housing market at a time when the peoples’ disposable income had been severely stressed by the oil price crisis. There was suddenly a glut of ‘subprime’ properties and their prices tumbled taking down the prices of the derivatives with them. The existence of widespread ‘leveraging’ greatly augmented the financial fall-out and huge financial institutions were on the brink of collapse.

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The collapse of these big institutions would have brought down the economies of the US and Europe – the still functioning firms would have been crippled by the freezing of the accounts that they had had in these banks. The resulting unemployment would have deepened the downward spiralling of the economy – the safety nets would have been sorely tested given the size of the problem. Given all of this, the Western governments did what appeared to be the only way out: they intervened strongly to save the financial system – they pumped in credit into the banks, took over some of the toxic loans, and underwrote the financial obligations of these institutions to stave off a complete collapse of the system. And the intervention worked – systemic collapse was averted.

But there was a price to pay. Many Western governments ran up huge deficits to save the banking system. They now had to turn to the financial markets (where the surplus funds of the ‘successful’ corporations” were parked) to meet their various financial obligations. But the financial markets are not running on the basis of charity. They assess each country’s capacity to pay back the hundreds of millions being asked for. If that country’s finances aren’t too great they may request higher repayment rates as its a more ‘risky’ loan. If that particular country is a ‘poor risk’ then the banks may refuse to lend as happened in Iceland and Greece. The government of such a country then might go bankrupt – again something that the other countries will not allow as that would cause too much turmoil. So the European Union stepped in with a loan – but this exacerbates the budgetary deficit in the EU countries.

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The European countries thus need to urgently trim their budgets now to reduce budgetary deficits and improve their standings in the ratings of the financial markets. This is the push behind the slashing of the social safety net that is taking place in several countries in Europe. However this slashing of social spending further constricts aggregate demand, which is, as explained earlier, the major underlying cause of the current economic crisis. Falling aggregate demand in the EU zone is also one main reason why unemployment has reached such high proportions in countries such as Tunisia and Egypt.

Regeneration and redistribution

Only a regeneration of aggregate demand on a world-wide scale can restore sustained growth of the global economy (which from an environmental point of view may not be the smartest thing to do). However such a regeneration cannot take place because it would require a more equitable redistribution of the wealth of the world – with a larger share going to the hands of the ordinary consumers. Though this is in the long-term interest of the major capitalists corporations, it is extremely unlikely that the biggest 500 corporations are going to agree to measures that will redistribute the world’s wealth more equitably, for it would mean that they would have to share a part of their profits. And as they are multinational now, the hands of government are tied. Attempts to redistribute income more equitably in a particular country will in all probability lead to capital flight from that country and unemployment.

The US’ attempt to stimulate the economy by putting more money in circulation (quantitative easing) is again fuelling speculative bubbles all over the world, as the underlying main problem has not yet been addressed: there just isn’t enough demand in the real economy to attract investment in industrial capacity. The world capitalist economy therefore is between a rock and a hard place. Given the intractable nature of the problem, we shouldn’t be surprised if the world economy goes into another recession this coming year, and we need to prepare ourselves so that the most vulnerable are taken care of. And the first step in that preparation is to decide whether you agree with this analysis. We do need a clear analysis of the problem to be able to steer the ship.

Jeyakumar Devaraj, an Aliran member, is the Member of Parliament for Sungai Siput.

The views expressed in Aliran's media statements and the NGO statements we have endorsed reflect Aliran's official stand. Views and opinions expressed in other pieces published here do not necessarily reflect Aliran's official position.

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Dr Jeyakumar Devaraj, a long-time Aliran member and contributor, served as Member of Parliament for Sungai Siput from 2008 to 2018. A respiratory physician who was awarded a gold medal for community service, he is also a secretariat member of the Coalition Against Health Care Privatisation and chairperson of the Socialist Party of Malaysia.
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