GLOBAL FINANCIAL CRISIS OF 2008 | US GOVERNMENT & WALL STREET HUBRIS?

? Sean Ian Fischer, 19 June 2024. All Rights Reserved. Contributor to Mustang Leadership Solutions Group?, LLC. First written 8 April 2022.

The Problem

The 2008 Great Financial Crisis (GFC) exposed the arrogance and hubris of the American financial system. In America, a balance between free markets and ethical conduct are a must in an experienced and advanced democracy. When financial markets go awry leading to the destruction of the lives of a society’s citizens, it is imperative that the government step in to provide the society with the necessary stability and security. In 2008, the GFC wreaked havoc on the global economy and its markets. The United States government did step in and provide relief, but the public and media perception was that the relief was targeted toward the very businesses and banks who engineered the crisis to begin with. There was no direct relief provided to the citizen. To add insult to injury, government relief to America’s corporations and banks were funded by the American taxpayer.

Fortunately, learning the lessons of the GFC, the United States acted swiftly during the Covid-19 global pandemic by providing stimulus not only to the private business sector, but also to its citizens in the form of direct payments and other indirect vehicles and instruments. True, this action had the ancillary effect of creating inflation with large amounts of dollars in the financial system, but it nonetheless enabled citizens to weather the storm of the pandemic better than had been done for the citizen during the GFC.

Evidence

All too often, governments and economists fail to recognize the human factor in its analysis. It is imperative that government bureaucrats and technocrats understand the thought patterns behind how economies work. In George A. Akerlof and Robert J. Schiller’s Animal Spirits they say that we “…will not understand economic events unless we face that their causes are largely mental in nature…this thought experiment fails to take into account the extent to which people are also guided by non-economic motivations…it fails to take into account the extent to which they are irrational or misguided. It ignores the animal spirits” (pp 3).

The 2008 GFC was caused by intangibles such as our changing confidence, temptations, envy, resentment, and illusions.[1] Akerlof and Schiller contend that there are five different aspects of animal spirits and how they affect economic decisions: 1) Confidence, 2) Fairness, 3) Corruption, 4) Anti-social behavior, and 5) Money Illusion. Whereas confidence is the feedback mechanism between it and the economy that amplify disturbances; fairness – the setting of wages and prices; the temptation toward corrupt and anti-social behavior and their role in the economy; money illusion where the public is confused by inflation and deflation and does not reason through its effects (pp 5).[2]

Akerlof and Schiller reason that the United States Federal Reserve (the Fed), using normal policy procedures and tools in a crisis has limited effectiveness. When the times call for more control, the Fed need to act accordingly, “There are limits to the effectiveness of such standard monetary policy when there is a loss of confidence, and businesses and consumers are loath to spend” says Akerlof and Schiller (Animal Spirits pp 74-75).

Central banks influence an economy through its control of the money supply. The Fed uses its control over reserves in two ways to affect the amount of money in the macroeconomy. The Fed has a large $500 billion (2009) portfolio with which to buy or sell bonds. The Fed can expand credit by lending directly to troubled banks by receiving collateral in return; contract credit by accepting repayment of these loans and re-discounting or lending at the discount window which affects the volume of reserves and amount of capital in the economy.[3]

“The old system of finance changed. In the old days, for the most part, those who originated loans kept them in their own portfolios…the proponents of the ‘new finance’ discovered all kinds of ways to package these loans (to ‘securitize’ them) and to divide up those securities…These financial products did not even need to be backed by underlying assets: they were promises to pay if some future event took place. Relying on a curious financial alchemy, investors combined these products in clever ways, thinking that they were thus able to exorcise the underlying risk.”[4] Akerlof and Schiller further explain in Animal Spirits that “The segment of the financial system that initiated loans, then passed them on, was fragile. It fell. In terms of our animal spirits, confidence disappeared. People became suspicious of transactions that they had previously undertaken to the tune of trillions of dollars…the sophisticated financing involving securitized debt and the derivatives (like credit default swaps and other financial futures) that seemed to be insurance for those debt packages had replaced a great deal of the old system (more or less) direct lending…the role of the central banks is to insure credit conditions that enable full employment.”

Possible Alternatives

At the core of any possible alternative is the necessity to maintain the trust and confidence of America’s citizens. “The public and the press do not like the idea of ‘bailing the banks out.’ It offends their – and our – sense of fairness. The public also fears – surely rightly so – that highly compensated bankers will somehow appropriate the funds from the bailout to increase their own bonuses” say Akerlof and Schiller (Animal Spirits pp 94).

The United States failed in their fiduciary responsibility in ensuring proper regulation and monitoring of the markets and exchanges in that it consciously allowed lending and the creation of instruments that had high elements of risk and toxicity for decades prior to 2008. Therefore, it should be the policy of the United States government, through the Security and Exchange Commission (SEC), the FDIC, the Federal Reserve, the U.S. Treasury, and others to ensure that there be a return to simplified and transparent financial instruments that do not transmit exponential risk to the United States or international markets such as that which trembled through the world financial system in 2007 and 2008.

This means that loans from an originating institution will be required to have the means to “cover” those loans by maintaining the necessary reserve capital on hand in the event of poor performing loans. Institutions will need “direct accountability” for the loans they issue, and they cannot “export” those loans to markets via credit default swaps (CDS) futures or similar derivatives. A combination of a return to more accountable banking practices with updated financial technology characteristics is the aim and goal.

Secondly, during the Covid 19 pandemic the United States government demonstrated that it could provide necessary stimulus to the private sector and its citizens keeping the society functioning and capitalized averting complete societal collapse. Actions such as these instill trust and confidence in government to act on their behalf in times of crises.

Solution Justification

The justification for ensuring that lenders have adequate capital on hand and are directly accountable for the performance of their loans instills trust and confidence in the banking system. As demonstrated in the 2008 GFC, the lack of direct accountability of these institutions led to the destabilization of the global markets, needlessly creating chaos and despair to those with the least ability to withstand even minor shocks. In 2008, the United States government failed to provide for the health, welfare, and safety of its citizens, as outlined in the United States Constitution, by burdening the citizen through taxation to bail out the private banking sector and not providing much needed direct stimulus to the citizens who desperately needed it. The United States government acted unethically and failed its primary function and purpose by not serving its citizens in times of crisis.

The United States government via the Chief Executive is directly responsible and accountable for the security and stability of the nation. It must never lose sight of its function and purpose to the citizen of the United States. The citizen has the ultimate power and authority under the American system who entrusts its proper and ethical functioning to the government of the United States. In times of crisis, the government must act in such a way as to return the nation to security and stability as expeditiously as possible and provide for its citizens.

ROOT CAUSE ANALYSIS

Politics and economics are inextricably linked. The United States outwardly chooses to believe it can separate the two, but in the US’s word and deed they are threaded together. This myth of separation of the two, causes great crises and strife in the United States and the world stage. In 2008, “…hundreds of billions of taxpayer funds were put in play to rescue greedy banks…majority of put credit creation is done by a tight-knit corporate oligarchy…at the global level, 20-30 banks matter…” (Tooze, Crashed, pp 12). American tax-payer dollars were used to bail out large banks because they were “too big to fail.” Why were they too big to fail? The average American citizen is most likely shielded from the realities of the banking system and how they are globally linked. They are the unwitting “underwriters” of large global oligarchic banking institutions who speculate with taxpayer money to advance their profits and have a nearly one hundred percent guarantee that if they fail in their speculative calculus, there is no price to pay because the taxpayer is there to catch their fall. With no direct accountability and being backstopped by taxpayers, via the United States government, it is no wonder then, that banks will continue to be creative and innovative in how they can increase their competitiveness and profits if there is nearly zero risk to themselves or national governments.

Discussion

Banks are the main creators of money in the world. In the past, it was the governments who produced the cash via their treasuries. When the world went off the gold standard upon Nixon’s declaration that the United States would decouple pegging the U.S. dollar to gold, the rules of money changed. Instead of the treasury issuing physical dollars the banks began to issue credit – i.e., loans -and those loans showed up on accounting ledgers as “cash.” But those loans still had outstanding balances – in other words they were not yet paid – so the “cash” did not exist. They are just numbers on a ledger. A promise, or more accurately a hope, that the borrower or debtor would repay his loan. In fact, the cash only materializes when a borrower/debtor paid back the loan in “real cash” that real cash was produced. In this way, banks “produce” money instead of coming from the treasury. Ninety percent of America’s “currency” is in the form of bank loans. Only three percent of the currency is actual physical cash (https://positivemoney.org/how-money-%20works/how-banks-%20create-money/).

As pointed out in the previous paragraph, it is not the national treasuries that issue the money, but large international banks and central banks. This means that the governments do not loan money to each other as may have been the case pre-Bretton Woods, but large commercial banks and central banks. The Federal Reserve (Fed) my decide to loan the European Central Bank (ECB) money, but they are only numbers. The US Fed is just sending the ECB a number that will appear on each’s accounting ledger: ECB owes $1T to the US Fed. Those dollars don’t become real until payments are made which are real dollars – i.e., the creation of money.

When John Maynard Keynes argued that the world is in a “gold cage,” that is, restricted to do things because of the developed world’s adherence to gold – pegging their currencies to gold – there was a fiscal discipline that could not be circumvented. Gold had been man’s creation as a source of value for many millennia. Gold was accepted as a store of wealth. Gold kept the international markets stable. Arguably the most stable the world had seen for those nations that adopted the gold standard in the nineteenth century onwards until August 15th, 1971, when US President de facto decoupled the world from the gold standard ending the era of the Bretton Woods agreement of 1944. The Bretton Woods Agreement made “…[the] dollar as the anchor of the global monetary system…it was tied to gold” (Tooze, Crashed, pp 10). This sent the worlds’ currencies into free float. Fiat money “…[C]alled into existence and sanctioned by states, it has no ‘backing’ other than its status as legal tender” (Tooze, Crashed, pp 10). “-” (Tooze, Crashed, pp 11). The U.S. Fed took on the role as the substitute “gold standard” by making the U.S. dollar the reserve currency of the world.

A new financial market revolution was inaugurated advanced by neo-liberalist “logic of discipline” (Tooze, Crashed, pp 11) that would maintain international fiscal and monetary world post gold standard. We just had to believe that humans would “do the right thing.”

It appears that much of the world levels the blame on the Americans for the 2008 Financial Crisis. At first review, this seems to be the case. President Richard Nixon closed the gold window in 1971 in order to address the country's inflation problem and to discourage foreign governments from redeeming more and more dollars for gold (https://www.investopedia.com/terms/n/nixon-shock.asp). This quickly becomes an exercise in asking the five questions, or in American parlance, the “5 W’s” where you ask five questions to uncover the root case of a problem. We’ve learned that President Nixon closed the gold window to address inflation created by America’s mounting war debt in Vietnam and to discourage foreign governments from redeeming their dollars for gold, as French President de Gaulle did. De Gaulle called Nixon’s bluff – he got his gold back. But where did the original problem stem from with America’s gold reserves?

Enter the United Kingdom (UK). The UK post World War I (WWI) and (WWII) was a declining global empire and world hegemon and became increasingly a debtor to the United States. The UK, via the City of London, created a new global mission for itself. It would become the “dollar broker” of the world. With Bretton Woods, the U.S. Fed and Treasury held controlling roles for the dollar and minimizing currency instability. In the 1950’s “[The] City of London created a new role for itself as the main hub for offshore global dollar financing…[it] developed as financial center and sidestepped contraints” (Tooze, Crashed, pp 80). British, American, European and Asian banks used London as center for unregulated deposit taking/lending in dollars (Tooze, Crashed, pp 80). With UK connivance, the City of London offered the basic framework for a largely unregulated financial market…dollar hegemony was made through a network via the City of London…the offshore dollars became a disruptive force that applied pressure and making the gold standard peg untenable” (Tooze, Crashed, pp 80). These root causes became a large part of President Nixon’s calculus to remove the US from the gold standard. Its origins were in the City of London.

Ever adaptable and profit-seeking, the American financial sector went to work creating innovative financial market tools and instruments. “America’s securitized mortgage system had been designed from the outset to suck foreign capital into US financial markets and foreign banks had not been slow to see the opportunity.” (Tooze, Crashed, pp 72). Foreigners owned a large part of American real-estate, around twenty-five percent being held by foreign investors Of this, Europeans owned the riskiest part of the market – subprime. Sixty six percent of commercial paper issued had European sponsors including fifty-seven percent dollar-denominated commercial paper. (Tooze, Crashed, pp 73). Europeans took out short term loans in dollars and loaned them out for longer terms. This meant that they did not have sufficient dollar reserves on hand if crisis hit them. They borrowed dollars to lend dollars. Contrary to accepted myth, the Europeans were the largest lenders to the United States in the early 2000’s, not the Chinese.

Conclusion

Basel I and Basel II largely left the international banking systems to self-regulate. Democracies like to allow markets to self-regulate. They do this in the belief that government regulation and interference disturb the balance of the markets correcting themselves through free trade. However, there is a very important factor that is routinely left out of this calculus. Human nature and human behavior. Without regulation, greed takes root and at great cost to citizens. American framers of the United States Constitution understood quite well this hubris of humans and created the balance of powers framework where all powers were intelligently checked by the other. Curiously, these balances of power or checks on power didn’t apply to human behavior in financial markets. Without some form of meaningful and enforceable regulation, international banking institutions will run amok and create ruinous conditions for citizens of those countries affected.

The genesis of the 2008 Financial crisis, from the analysis above, did not begin with American financial technology innovations when America left the gold standard, but actually originated with the City of London and its unregulated “dollar exchange” market that it ran with impunity from the 1950’s onward. The American creations and innovations were in fact not novel at all but came from British “fintech” and adapted to the updated and changed environment of the decoupling from the gold standard by President Nixon. These financial tactics and techniques had British origins and not American, but all played the game because it suited their shareholders and bottom line. With Basel I and II, and the City of London’s little to no regulation, capital flows were largely unregulated.

With little to no regulation, no gold standard, fiat money, the banks’ ability to overtake treasuries in the “production of money” (thus by-passing government responsibility and accountability – i.e. via treasury departments), dangerous instruments and packaging of mortgaged backed securities (MBSs), and others, the combination was rife for a fiscal reckoning and a return to fundamental laws of nature. That reckoning occurred on September 16th, 2008, with the fall of Lehman Brothers.

With banks’ ability to “create money” and lend it to each other, they outflank national governments and their treasuries. The oligarchy of banks become their own unregulated hegemon. Basel I and Basel II provide them these protections from accountability stating that they will be allowed to legally “self-regulate.” Governments allow the banks to “produce” money. Central Banks are autonomous institutions with no transparency. When corporate hubris runs amok it is the common citizens who are mostly oblivious to these complexities, and then they are asked to pay the bill because they have unwittingly provided the oligarchy of banks with an insurance policy allowing them to speculate and tinker at will with no consequences.

The only way to reverse, regulate or make the international banking system operate in a responsible way is to strip them of these legal powers to act in destructive and irresponsible ways. Despite the na?ve belief that markets are all knowing and self-correcting, history has proven that they are in fact not so. Checks and balances have to be injected into the international banking system. The Federal Reserve/Central Banks have to be audited and regulated and their operations must be made public to their citizens. Tax payer money demands accountability especially if there is a corporate expectation that citizens will be the underwriters of their many nefarious, self-serving and profit-seeking motives. Governments need to be the honest “brokers” between businesses and its citizens. If the governments continue to fail in their raison d’etre, then as it is written in the United States Declaration, it is the duty and obligation of the citizens to overthrow those governments in favor of responsible government for the people and by the people.

Bibliography

George A. Akerlof and Robert J. Schiller, Animal Spirits, 2009 Princeton University Press.

Costas Lapavitsas, Profiting Without Producing: How Finance Exploits Us All, 2013 Verso.

[1] Animal Spirits, George A. Akerlof and Robert J. Schiller, 2009 Princeton University Press

[2] Animal Spirits, George A. Akerlof and Robert J. Schiller, 2009 Princeton University Press

[3] Animal Spirits, George A. Akerlof and Robert J. Schiller, 2009 Princeton University Press

[4] Animal Spirits, George A. Akerlof and Robert J. Schiller, 2009 Princeton University Press