The financial bust of 2008

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Paul Volcker is the father of the debt crisis that still haunts the poor countries of the world. Following his lead, in 1979 central bankers declared inflation, and not unemployment, the number one priority for policy makers. G7 heads of state and governments meeting in Venice that year backed him up.

Subsequently, Volcker, from his perch at the Federal Reserve, engineered an increase in the international dollar interest rate or LIBOR (London Interbank Offered Rate), from eight per cent in 1979, to fully 16 per cent by 1981. This brought on the subsequent crash of the world economy, the great recession of 1982.

Governments which had contracted sovereign loans from banks eager to re-cycle petrol profits saw the cost of their loans double. With no opportunity to double their export earnings of dollars (needed to pay for the loans) poor countries had to go deeper in debt. Many still suffer the consequences, despite the best efforts of Jubilee 2000, Bono, and Drop the Debt.

This past week, Volcker, in a landmark New York speech, read a lesson in central banking to current Fed Chair Ben Bernanke; and he also announced that financial markets had "failed the market test." But he was unable to answer the crucial question of what to do next.Though criticizing a successor Fed Chairman is not allowed under the insider rules of the old boys club that rules in world finance, Volcker came close. In his speech, he remonstrated Bernanke for going to the very edge of the legal limits to Federal authority to bail out the Bear Stearns investment bank.

Then Volcker said that by guaranteeing the bad loans made by the 20 New York investment banks that are authorized to deal in U.S. government securities, the Federal Reserve had abandoned the tried and tested rule central banks have always followed when using public credit to rescue financial capitalism: only lend against good collateral. Currently the Fed is turning over as much as $100 billion a month to its expanded list of client institutions, and taking on bad debts in the process.

The current Fed Chairman is desperately trying to stop the U.S. economic downturn — a recession — from turning into a depression. So, he has reduced short-term interest rates by three percentage points in six month, from 5.25 per cent to 2.25 per cent, and watched the U.S. dollar drop by an average of 10 per cent against the currencies of its 17 biggest trading partners, and 15 per cent against the Euro, in the last 12 months.

Ben Bernanke made an academic reputation as a specialist on what went wrong in the 1930s, and he fingered monetary policy and the Fed, as the culprits. For Volcker, however, the current Fed chair, by fighting recession, has taken on the role that is rightly played by the White House, the U.S. Treasury Secretary and the U.S. Congress. For Volcker, the Fed has one primary concern: protect the currency, the U.S. dollar; and one major policy objective: fight inflation.Volcker believes that instead of lowering interest rates, the Fed should be raising them. If anti-recession spending is necessary, says Volcker, the U.S. government should act.

Volcker does not think much of the fortunes being paid financial market high rollers. Supposedly, investment bankers, as lenders make huge rewards because they take big risks. It turns out that the punishment for investment bankers being wrong about mortgage debt, and much else, is seeing their firms included in the list of those who get bailed out as a part of the anti-recession/depression stance of Bernanke, and the Fed. Individual financiers fingered for mismanagement, leave with huge bonuses, pensions, and benefits.

Market rules do not include punishing bankers for making bad loans.Potential losses from the unregulated financial system are stupendous. The very conservative IMF suggests total write-offs by financial institutions worldwide will total nearly $1 trillion dollars. Since known write-offs to date total only about $250 billion, that means we have another $750 billion to go. The "cascading breakdown of the system as a whole" referred to by Volcker is still a distinct possibility.

The G7 Finance Ministers met in Washington over the weekend and have recommended a modest re-regulation of financial institutions. It would be appropriate for others to work out a full-scale replacement of the existing system.

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