New Labour's borrowing bombshell

When the government borrows, who does it borrow off? This question from a reader arose in response to Monday’s crisis budget, when chancellor Darling announced record sums of borrowing. It’s an arrow that gets straight to the heart of the problem.

The straightforward, short-term answer is that the government offers to borrow money from anyone who wants to lend it. In exchange, it offers “government bonds” or gilts, the original form of securities which, in the old days, were considered relatively low risk, because they were guaranteed by the state. And, so the theory went, governments can’t go bankrupt, because they control the issue of money – one of the many forms of credit.

In the longer term, there’s the question of paying the loans back, with interest. Governments raise the money to repay borrowing by taxing the creation of value, and value is created when people work, by the people who do the work. But the historically unprecedented scale of the expansion of credit over the last 30 years has changed things out of all recognition.

Now Martin Wolf, chief economics commentator at the Financial Times, says “the horrific numbers” in the pre-budget report might well lead to a questioning of the creditworthiness of the UK government. “A creditworthy government”, Wolf says, can shift excess debt from the private sector on to the backs of taxpayers. An uncreditworthy government cannot. If the cost of debt becomes too high, the latter will be forced into default, either openly or via inflation. In the UK’s case, inflation would be triggered by a flight from sterling.”

In other words, if the government is unable to raise the money through taxes to repay the “horrific” level of borrowing it will be in default, be bankrupt, become a failed state. A bit like Zimbabwe. In fact, the markets are already beginning to consider this possibility. The cost of insuring against the British government defaulting on its gilts in the next five years surged this week.

Darling makes assumptions about the future trajectory of the economy that don’t impress anyone. Wolf says “…the Treasury surely remains too optimistic: despite the scale of the shock to the world economy and the financial system, it assumes an annual peak to trough decline in GDP of a mere 1 per cent; an economic recovery in the second half of next year; and then a return to trend growth at 2¾ per cent a year, despite the need to shift output into capital-intensive, export-oriented manufactures. This is not plausible.”

That’s putting it mildly. The effects of the crisis have already erupted onto the high streets with big names Woolworth’s and MFI in administration, Curry’s and PC World making big losses. In and around Llantrisant, the home of the Royal Mint in Wales, hundreds of jobs have been blown away in a few hours, in Bosch car components, Oreal and Budelpack cosmetics, Hoover, the Serious Food Company and Ferrari’s – a chain of bakery shops.

Yesterday, representatives from the building industry and car manufacturers got to the head of the queue of those trying to persuade the government to help them stave off bankruptcy. They went away empty-handed, apparently. The government’s tax income is destined to fall off sharply for years to come.

There’s a bit more to this excellent question. Earlier attempts to raise impossible levels of taxes have produced social unrest and political change. In 1381, the most extreme and widespread insurrection in English history, the Peasant’s Revolt, was triggered by the poll tax. It was the beginning of the end for a society based on exploitation through landownership. Attempts by Charles I to raise money without recourse to Parliament contributed to the English Civil War and his execution in 1649. On March 31 1990,there were riots in London against the Community Charge, commonly known as the poll tax. Watch this space.

Gerry Gold
Economics editor

The storm is just starting to blow

Gordon Brown is being feted as the “master of the universe”. Stock markets yesterday were delirious with joy, making record-breaking, stratospheric leaps yesterday as governments around the world bailed out the banks. Right-wing Tory newspapers joined in unalloyed praise for the bankers’ government.

Is the financial storm over then? Er, no actually.

So far, sums approaching £2,000 billion (= £2 trillion) of taxpayers’ money has been committed by the governments of America, the UK and Europe to the bankers’ bail-out. Central banks are pouring “unlimited” amounts of US dollars into the global financial system in what will prove yet another failed attempt to prevent the mother of all meltdowns.

How can we be so sure?

Yes, £2 trillion sounds a lot, but the collecting bucket is effectively bottomless. This unimaginably large sum of money is dwarfed by a series of other giant hot-air balloons of fantasy finance queuing to burst in the background whilst Brown’s Punch to the bankers’ Judy struts temporarily in the foreground.

Among the balloons is the market in credit default swaps (CDS), a way of trading in risk. It began life in the mid-1990s and, largely because it has always been unregulated, and appeared to offer the possibility of reducing, or at least sharing risk, it attracted a great deal of interest.

The simple version of the story goes that a swap enables an organisation making a loan to a customer to insure against the customer defaulting on payments by establishing a private contract with a third party, paying a kind of insurance premium. It can’t be called “insurance” because that would make it liable to regulation. You wouldn’t want to call it “protection” either. People might think you’re a gangster.

The market grew very fast. Most major organisations are now caught up with each other in a lacework of interconnected contracts. Ok, so how much are we talking about? It’s difficult to be precise, because all the trading is in unregulated contracts hidden from public view. Nobody really knows. Data from the International Swaps and Derivatives Association (!) show that at the end of June, the CDS market had a notional value of $54 trillion. That's the same as the planet's 2007 GDP and nearly four times the value of all shares traded on the New York Stock Exchange. Other estimates puts the figure nearer $65 trillion. So what is the chance of this particular balloon bursting? It already did. On Friday, Moneyweek put it like this:

“When one side of a trade defaults, it starts a chain reaction that raises the risk of others losing money. That's called 'counterparty risk', and is partly what has spooked investors into selling off assets and lenders into curbing credit. The collapse of Lehman Brothers has had a particularly big impact. Lehman wrote more than $700bn-worth of CDS. Now it's gone bust, investors who had taken out these CDS have been left without the insurance, so they're having to buy more, even though prices are now rising because of the general turmoil.”

Initial results of the auction to determine the value of CDS on Lehman Brothers showed banks, hedge funds and other sellers of protection facing losses in the area of 90.25% of the insurance they sold.

The CDS market is only 10% of the global derivatives market, which covers all contracts taken out to minimise risk. This is the mysterious, unregulated world of futures, forwards, options and swaps. According to the Bank for International Settlements, the notional amounts outstanding at the end of 2007 totalled about $550 trillion on contracts privately traded between parties. As the global recession deepens, the number of parties unable to fulfil contracts will grow rapidly.

Is the storm over? It’s only just beginning to blow!

Gerry Gold
Economics editor

Post-capitalist irony

Ironically, the best case for the abolition of private ownership of production and finance is now being made by capitalism itself. For example, banks which until just a few months ago were firmly in the private sector are now state owned or controlled. As yet, the world as we know it has not come to an end following this remarkable turnaround.

Of course, George Bush and Gordon Brown have not become revolutionary anti-capitalists. Their actions are desperate moves to prop up the failing international financial system and save it from total collapse. Every day there’s another frantic response. Yesterday, America’s Federal Reserve made $30bn available to central banks in Australia, Denmark, Sweden and Norway, to ease money markets. The American government is printing money like there is no tomorrow.

What the crash of 2008 is demonstrating, however, is that a) the market-driven capitalist economy and financial system has failed big time b) there is no iron law that says private ownership is necessary and c) there are alternative ownership models which can actually work.

So the crisis itself indicates the solution. Shareholder-owned and profit-driven corporations and banks have produced chaos and an impending catastrophe. Let them be commonly owned and run for the benefit of society as a whole. Of course, the capitalist state and proxy governments like New Labour are only interested in keeping the system going, if at all possible, whatever the social consequences in terms of unemployment, repossessions and lower living standards. They intend to either wind up or hand back to the private sector the enterprises they have nationalised.

Yet this assumes that the financial crash is now under control and manageable. Some superficial observers even believe that current events lead back to a much more conservative financial system, where credit/debt is much reduced and the regulatory framework is tightened up. This back-to-the-future fantasy scenario is championed by liberal commentators like the Guardian’s economics editor Larry Elliott and Will Hutton, chief executive of the Work Foundation.

Serious analysts know that the credit crunch is only just beginning, however. The unravelling of countless trillions of dollars of fictitious “assets” has a long way to go and will be reinforced by the impact of recession, falling house prices and lower consumer spending. All eyes are now turning to another mysterious area – credit default swaps (CDS).

These are insurance-like contracts that promise to cover losses on certain securities in the event of a default. They typically apply to municipal bonds, corporate debt and mortgage securities and are sold by banks, hedge funds and others. Contracts can be traded — or swapped — from investor to investor. The instruments can be bought and sold from both ends — the insured and the insurer.

The CDS market exploded over the past decade to more than $45 trillion by mid-2007, according to the International Swaps and Derivatives Association. This is roughly twice the size of the US stock market and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market. The top 25 American banks hold more than $13 trillion in CDS instruments. As asset prices plummet and companies go bankrupt leaving nothing but bad debts behind, the CDS market is ready to implode.

Yet another powerful reason to refuse to pay for the bankers’ crisis and to mobilise for the Stand Up for Your Rights festival on 18 October.

Paul Feldman
Communications editor