Thursday 25 August 2011

Bank Profits & Leverage

There is something peculiar about banks. They borrow cash from people, companies and governments, and lend to people, companies and governments. They deliver ‘financial services’. But, in the process, the closest they ever come to producing anything is when they provide the funds for somebody else to do the producing. Despite this, they gain a great deal of profit. This article is about bank profits and the influence on profits of leverage.

The nature of banks

The modus operandi of banks has traditionally been to attract surplus funds from the broad economy, and to pay interest on these funds at a rate less than they will earn from investing these funds. In the past couple of decades, however, an increasing proportion of bank profits has come from financial activities beyond simple borrowing and lending. Banks might also take fees from companies when issuing their bonds or equities to other investors, or for giving advice on mergers and takeovers, or they might profit from their own dealing in currencies, interest rates, commodities and derivatives. Nevertheless, banks are in the business of financial market transactions, at most speculating on or taking a cut from what other people are producing, rather than producing anything themselves.

Banks do produce for themselves an often impressive profit, but that is based on deriving revenues from business undertaken elsewhere. Even when banks provide critically needed financing, or offer advice and deals that save a company money compared to what it might otherwise have done, the profit they make is based on the surplus that some other business has made. For the UK, the US and some other financial powers, this parasitic role is not seen as a disadvantage. In those countries, the banking system is seen as a key part of the strength of the domestic capitalist economy. This is because their banks can attract significant revenues from other countries. It doesn’t matter where the wealth is produced; it only matters where it is appropriated.

Profits & leverage

Compared to industrial and commercial companies, banks have a big advantage when it comes to making profit. They can use their privileged position in the financial system to borrow at relatively low cost, whether from individual savers, from companies, or from state funding via the central bank. Given the billions of transactions they undertake, they can also count on support from the state when things go wrong, especially if they are ‘too big to fail’. Trouble for the banks means trouble for the capitalist market system.

Bank profits derive from the difference between their borrowing costs and the earnings on their investments. Also, the more they borrow, the more earnings potential they have – via loans, trading positions, taking the risk of underwriting securities, etc. The only limit to such borrowing is when it looks ‘too high’ compared to the underlying investment, or equity, in the bank itself. More borrowing means that a bank can use the funds to buy more assets on which to make a return. This increases the bank’s ‘leverage’, the ratio of its total assets to its equity capital. But as the leverage rises, the bank risks losses on its investments that might eat into its underlying capital - eventually making it insolvent.

As for many other notions in finance, the definition of excessive leverage is a flexible one, determined by what is considered to be ‘normal’.[1] It turns out that a leverage ratio of up to around 20 for banks is considered fine, since this has not been associated with big losses in the past. The risk of loss increases when there is a lot of borrowing at a fixed cost of funds against assets that have a variable rate of return. Higher leverage means that a small drop in earnings on assets – especially through non-payment of debt or default - can wipe out profits completely, since the costs of the borrowed funds still have to be paid.

Leverage is used by industrial and commercial corporations, as well as by banks and other financial companies. However, the former have little ability, unlike the banks, to attract cheap funding, and in any case are more focused on production and distribution, rather than on financial transactions. Therefore they usually have much smaller leverage ratios than banks. Data for US manufacturing companies, for example, show that stockholders’ equity has been higher than corporate debt in the past decade.

To make the issue of bank leverage more clear, consider an example where a bank has $5bn of shareholders’ capital and it borrows another $95bn in the market to fund its total assets of $100bn. In this case, its ratio of total assets to equity, or leverage, is x20, because the assets of $100bn are 20 times higher than the shareholders’ capital. Things go well for the bank if its cost of funds is below the return on its assets. If it pays 4% for its funds, the interest bill is $3.8bn, whereas if it earns 5% on its assets, the return is $5bn. What looks like a small 1% margin of return generates a net income of $1.2bn, and this is measured against the $5bn of equity. So the return on equity is 24% (the $1.2bn divided by $5bn). It would be lower if the costs of its operations are included, but these are excluded in these examples to simplify the picture.

If the bank then expands its business by borrowing even more, it can potentially boost its returns dramatically. For example, if it borrowed $195bn then, with its $5bn of equity, it could fund $200bn of assets. The leverage ratio would now be x40. If the cost of funds were still 4%, it would have to pay a massive $7.8bn in interest on the $195bn, but it would receive $10bn in revenue if the rate of return on the $200bn were still 5%. This gives a net $2.2bn of revenue against the $5bn of equity, thus a return on equity of 44%. Here, the increase in leverage has worked and the return on equity has soared. But the risk was that the assets might not return as much as the previous 5%. Once the average return falls below 3.9%, not much of a drop, the bank starts to make a big loss.

This example of increased leverage might look extreme, but something like this, or worse, was going on in the speculative boom of the 2000s. Up to 2007-08, banks in all the major countries increased their borrowing from financial markets to fund more investments and boost their profits. This borrowing pushed their leverage ratios from around the x20 level to extraordinary heights. Chart 1 shows that in 2007-08, the average leverage ratio was x40 or higher in the US and Europe, with the assets of some large banks even reaching x60 or x100 compared to their equity.

Chart 1: Global bank leverage ratios, 2007-2011 *

Source: Bank of England

Notes: * The longer-term average leverage ratio is close to 20. LCFI means ‘large complex financial institution’ - essentially a big bank with diverse operations. Company accounts have been adjusted to make the data comparable between different countries.

This extreme leverage was an important dimension of the financial boom, and it accentuated the financial collapse once the delusions of ever-higher revenues were shattered. In 2008, at the height of the crisis, every major bank in the US, UK and the rest of Europe registered a plunge in profits, with the sector as whole in each region showing a loss.[2] Since 2008, banks have cut their leverage ratios sharply, by selling or writing off assets and by getting more equity capital investment. In early 2011, these ratios were much closer to their longer-term averages, though this is not to argue that the banks are by any means in a healthy financial position, given that they face rising levels of bad debts and still have huge volumes of dud assets.

Bank subsidies, post-crash

Bank profits were obviously hit by the crisis, and lower levels of leverage have now reduced their potential for ramping up profits. However, profits since the crisis have recovered to some degree, helped by state provision of close-to-zero interest rate funding in the US and UK, and by very low rates in the euro countries. Even where funds have not been directly provided by the state, explicit or implicit guarantees provided by governments have enabled many banks to get funding from the market at much cheaper rates than their real financial position would otherwise have allowed. The spread between banks’ borrowing and lending rates has also widened, increasing their interest income.

A senior Bank of England executive has done a useful estimate of the value of the ‘state guarantee’ subsidy to the major UK and global banks between 2007 and 2009:

‘For UK banks, the average annual subsidy for the top five banks over these years [2007-2009] was over £50 billion - roughly equal to UK banks’ annual profits prior to the crisis. At the height of the crisis, the subsidy was larger still. For the sample of global banks, the average annual subsidy for the top five banks was just less than $60 billion per year.’[3]

As his report put it, ‘these are not small sums’.

Imperial leverage

Previous articles on this blog have shown how declining profitability prompted capital to move away from productive investment into the easy profits of finance, leading to a credit-fuelled boom and bust.[4] The purpose of this article has been to highlight the important role of borrowing by the banks. Higher leverage ratios enabled banks to boost their profits in the upswing, but their extra assets were the debts of others. Now a lot of the debt cannot be repaid. The huge costs of the debt crisis are evident to all, and the shock to the system has led to government inquiries and proposals for reforming the financial markets. However, for the US and the UK, in particular, the financial sector is a key dimension of their economic power as imperialist countries. The US and UK financial systems play a major role in profitably financing the two chronic deficit countries. It is also, one might say, an important part of their ‘leverage’.[5] Anglo-American policy makers are not happy that the costs of the crisis are so high, but they will not do anything to undermine the position of their banks, even if they do decide to constrain some more reckless banking activities.

Tony Norfield, 25 August 2011

[1] There are different definitions of leverage, although each refers to some measure of assets versus capital. Different accounting standards also deliver different numbers. The overall trends up and down tend to remain the same, however. In this article, the basic definition used is bank assets divided by shareholders’ capital, which is the sum of the value of equity capital issued plus retained profits. Confusingly, some other measures of leverage express the ratio as the inverse of the one used here, with capital divided by assets, so a x20 leverage ratio is expressed as a 5% capital/asset ratio.
[2] See Bank of England, Financial Stability Report, June 2011.
[3] See Andrew Haldane, ‘The $100 billion question’, Bank of England, March 2010. This report is of interest for looking at the systemic costs of banking, and for calling the banking industry a ‘pollutant’ with ‘noxious’ by-products. This is from an Executive Director of the Bank of England, responsible for Financial Stability!
[4] See in particular, ‘Anti-bank populism in the imperial heartland’, 5 July 2011.
[5] The US has commonly used financial sanctions against disobedient countries, especially with regard to Iran. The UK has also made ample use of its financial influence, including, more recently, its control over Libyan funds based in London. For the role of finance for the UK, see ‘The Economics of British Imperialism’, 22 May 2011 on this blog. Some notes on the US are in ‘The Real US Debt Problem’, 26 July 2011.

Monday 22 August 2011

Libya is for Everyone?

These are some factors to bear in mind when assessing the fall of Gaddafi’s regime in Libya:

1. The European powers are now best placed to gain influence in Libya, especially Britain, which had already led the way in rehabilitating Libya back into the imperialist fold under Gaddafi. Britain’s BP had already struck oil and gas exploration deals with the regime in 2007 – its ‘single biggest exploration commitment’.[1] Alongside this, the LSE (latterly dubbed the ‘Libyan School of Economics’ after the Saif Al-Islam fiasco) was busy mentoring the Libyan elite in the wonders of ‘governance’. This was no doubt encouraged by the UK Foreign Office in order to gain influence over a new generation of rulers.

2. Libya is a rentier state, with the main spoils from energy revenues going to Gaddafi and his clan. There was normally enough left to distribute to other clans to keep them quiet; if not, then political repression kept the regime in place. However, political unrest grew after the Arab spring, which appeared to open up the possibility of regime change to Gaddafi’s disparate clan rivals. Gaddafi was fine for Britain and other powers while he was unchallenged and was becoming a stable partner. Post-Tunisia and post-Egypt, he was not.

3. The Libyan Investment Authority had been responsible for investing surplus oil funds and had assets valued at over $50bn in mid-2010. Before the sanctions on Libya earlier this year, it had already been suckered by western banks into loss-making bets on things like Société Générale shares and investments promoted by Goldman Sachs, and others, that lost almost all their value. Apart from the potential oil and gas revenues, control or influence over these funds will also be of great interest to western powers.

4. The NATO attack on Libya was initially promoted by Britain and France. Starting out under the usual false flag of ‘humanitarian intervention’, it quickly became an overt means of promoting regime change by backing one side in a civil war. The Libyan rebels in Benghazi quickly fell into the arms of western powers, with British intervention to open up ‘discussions’ being prominent. Since the end of July, the National Transitional Council has had an ambassador in London, after the expulsion of Gaddafi’s staff. The British have also been releasing previously-frozen Libyan funds held in London to finance the NTC. Today, the Financial Times reports that Britain’s office in Benghazi (!) has deployed a UK-led ‘international stabilisation response team’ to back up the NTC and ‘a separate British team is helping to build command and control capacity and assistance including communications kit and police training’.[2]

5. The US provided most of the firepower for the attack on Libya, but has effectively been sidelined by the British and the French. Italy, busy with the Berlusconi show, has had little role, despite being the previous colonial power and having extensive economic and financial relationships with the country. Over 20% of the Libyan Investment Authority’s $6bn equity investments are in Italian companies, eg Unicredit and ENI.

6. So far, Libyan events look like a big success for British imperialism: regime change to a more pliant group, big deals ahead, and at a cost of less than £300m for the military budget. But the ‘new Libya’ will still be fought over by the other powers, and the US will be unimpressed with spending $1bn to subsidise British strategy.

In the early hours of this morning, speaking on the Libyan opposition's TV network, Mahmoud Jibril, chairman of the NTC said ‘Libya is for everyone and will now be for everyone’. He meant that all Libya’s people would now participate in building the country, but the real message for imperialism is that Libya is now up for grabs.

Tony Norfield, 22 August 2011

[2] See ‘Cameron welcomes Gaddafi retreat’, Financial Times, 22 August 2011.

Tuesday 16 August 2011

The US Constitution: ‘We, the Capitalists’

Some years ago, I had reason to visit the offices of Moore Capital, the major US macro hedge fund, in Mayfair, London. In pride of place on a wall in the foyer was a copy of the US Constitution, said to be one of the ‘originals’. A valuable historical document, no doubt, though it was only much later that I looked a little closer into its actual history. This was when chancing across an old text in a bookshop with the intriguing title An Economic Interpretation of the Constitution of the United States, by Charles A Beard. First published by Macmillan in 1913, this was a 1961 edition, and also a snip at just £2.

For all the claims of democracy that usually resound when the US Constitution is discussed, little attention is paid to the economic interests that drew it up. Beard did focus on the economics, to much controversy when his book was first published. At that time, there were heated debates over the split in the Republican Party and conflict over the popular election of US Senators, worker compensation and other social legislation. Beard freely admits that his book is a ‘long and arid survey’ (and, mostly, it is), and he draws his conclusions after marshalling a huge amount of evidence from the period leading up to the adoption of the Constitution on 17 September 1787.

This is a summary of what he found (pages 324-325 of the book):

“The movement for the Constitution of the United States was originated and carried through by four groups of personalty [ie property] interests … money, public securities, manufactures, and trade and shipping.

“The first firm steps toward the formation of the Constitution were taken by a small and active group of men immediately interested through their personal possessions in the outcome of their labors.

“No popular vote was taken directly or indirectly on the proposition to call the Convention which drafted the Constitution.

“A large propertyless mass was, under the prevailing suffrage qualifications, excluded at the outset from participation (through representatives) in the work of the framing of the Constitution.

The members of the Philadelphia Convention which drafted the Constitution were, with a few exceptions, immediately, directly, and personally interested in, and derived economic advantages from, the establishment of the new system.

“The Constitution was essentially an economic document based upon the concept that the fundamental private rights of property are anterior to government and morally beyond the reach of popular majorities. …

“The Constitution was ratified by a vote of probably not more than one-sixth of the adult males.

“The leaders who supported the Constitution in the ratifying conventions represented the same economic groups as the members of the Philadelphia Convention; and in a large number of instances they were also directly and personally interested in the outcome of their efforts.

“In the ratification, it became manifest that the line of cleavage for and against the Constitution was between substantial personalty interests on the one hand and the small farming and debtor interests on the other.

“The Constitution was not created by ‘the whole people’ as the jurists have said … it was the work of a consolidated group whose interests knew no state boundaries and were truly national in their scope.”

So that was why Moore Capital had the document on the wall.

Monday 8 August 2011

Debt & Austerity

Debt is the common denominator in the crises facing the US, Europe and most of the major capitalist countries. But debts are a problem because of the pervasive and intractable nature of the global crisis. Governments now find that the extraordinary measures they took to boost growth after 2008 are no longer working. This is why their policies will now take a more aggressive turn towards austerity.

Private debt drivers

Although the focus of government policy measures in most countries is to curb public spending, the crisis did not start out as a government debt crisis. Private sector debt is much bigger than government debt in every country outside Japan, and its growth has also been faster. A McKinsey study shows that from 1995 to 2007 (the year before the crisis struck), the stock of private sector debt in 79 countries rose from $42 trillion to $107 trillion.[1] The volume of outstanding public sector debt was smaller and it increased less rapidly, from $13 trillion to $30 trillion. But in the next three years to the end of 2010, public sector debt grew more quickly as the state took on private sector liabilities to try and bail out the system. It jumped by $11 trillion, while the private sector debt pile rose by another $9 trillion.

Chart 1 gives a snapshot of global debt at the end of 2010. The numbers show the size of the outstanding debt as a percentage of GDP in each country or region. Each bar shows the division of the debt into (bank) loans, private sector bonds and public sector debt securities. Two things come out clearly from the numbers.

Firstly, the relative size of the total outstanding debt in the richer countries is much higher than for poorer countries. For the US, Japan and Western Europe, the totals are between 330% and 390% of GDP. By comparison, China, India and other developing countries have debt levels below 200% of GDP, and even less than 100%. McKinsey’s report argues that it is because the poorer countries have less developed capital markets; the more important point is that they have been far less dependent on credit-fuelled growth than the rich ones. The rich countries’ dependence now sees them drowning in debt.

Secondly, only in Japan is public sector debt the largest component of the total, reflecting that country’s decade-long stagnation. In the US and Western Europe, private sector bonds (issued by both financial and non-financial companies) and loans (both securitised and non-securitised) are much larger than public sector debt. A similar pattern is found elsewhere. While public sector debt might have been an important driver of the latest debt crisis for some countries, the data show that this is not true for most countries and regions.

Chart 1: Global debt outstanding at end-2010 as a percentage of GDP

Source: Author’s calculations based on data in ‘Mapping global capital markets 2011’, McKinsey Global Institute, August 2011.

In the early 2000s, major countries cut interest rates to try and offset stagnating growth. Private capital then began a credit-fuelled boom, but this turned to bust in 2008 as it became clear that the debts could not be repaid. The US sub-prime fiasco was the main trigger, but the reason that the crisis spread so dramatically around the world was that many countries were already vulnerable from their own versions of the credit boom, even if they had no exposure to the defaulting US mortgage securities. Credit expansion and speculation had been on a huge scale, so governments were forced to take on private sector debt liabilities or risk a ‘systemic problem’ - the problem that the capitalist financial system could no longer function. The ‘unsustainable government debts’ result from the crisis of private sector capital accumulation.

Running on empty

The crisis has trashed many totems of ‘free market capitalism’. Major financial companies were nationalised, while central banks abandoned conservative policies, bought junk, discarded their sacrosanct inflation targets and slashed interest rates. Global growth recovered somewhat after 2009, but the main impact of these policies was to boost stock market and commodity prices, not investment. In 2011, growth in the major capitalist countries has more or less ground to a halt and equity markets have slumped again. But governments now find they have now run out of options to boost their economies, either through monetary policy or through more government spending.

On monetary policy, interest rates are already close to zero in the US, UK and Japan, and only 1.5% in the euro countries. Central banks have also tried to boost their economies with ‘quantitative easing’ – which means buying junk assets from the private sector and financing government debts directly with central bank money creation. Just three or four years ago, such policies would have been described as debasing the currency, risking hyperinflation or acting like a dissolute Latin American dictatorship.

The Federal Reserve has $900bn of mortgage-backed securities on its balance sheet (as well as $1.6 trillion of US Treasury debt).[2] The Bank of England has a scheme to buy up £200bn of assets in its smaller version of ‘quantitative easing’,[3] while the European Central Bank bought €60bn in covered bonds from private banks, €74bn of government bonds from Greece, Ireland and Portugal, and has other exposures to asset backed securities and commitments to fund national euro money markets.[4] Today (Monday, 8 August) the ECB bought Italian and Spanish government bonds to try and stem the contagion. There is no reason to believe that these schemes will do anything other than slightly postpone the day of reckoning. Japan has run its own version of zero interest rates and quantitative easing since 1999, with no escape from prolonged stagnation and high debt levels.

Neither is there any way out of the crisis through increased state spending. This is a time-honoured policy recommendation from social democratic politicians and Keynesian pundits. But today public sector debts are so big that it is laughable to suggest that more spending would do any good. McKinsey’s report notes that government debt now equals 69% of global GDP, a dramatic jump from 55% in 2008. This is why, in the UK, the most that the Labour opposition can argue is that planned government spending cuts should be scaled down. In the US, one day after Congress reached a deal on raising the borrowing limit by an initial $400bn, 60% of the extra limit level was used up! It is little wonder that the US credit rating was downgraded.

Debt reckoning

A credit boom drove capitalism’s escape from stagnation at the turn of the millennium. This built a shaky edifice of debt, towering over the whole system. There is no pre-determined point at which the edifice will collapse, but the higher it gets, the more vulnerable it is to the slightest jolt. Governments have tried to prop up the structure, but now the debts have to be reduced or the system will topple. Extending further credit does very little to spur capitalist growth, and debts would just continue to grow faster than the prospects of paying them back. This should not be surprising, since the dynamic behind the rise in debt levels in the first place was the deteriorating profitability of investment.[5] Conditions for profitable capital accumulation need to be restored before extending any more credit will have a significant effect. This leaves two issues for capitalism to address, and for the rest of us to recognise and deal with.

First is what to do about the existing debts. Either the debtors pay in full, or the creditors accept that they will get less back than they bargained for. A ‘nobody pays’ solution does not exist. If the creditors forgive the debts, then they will take the hit, or current and future taxpayers will when the government bails out the financiers. If the debtors have to work harder to earn extra income, or sell their assets to generate cash to pay off their obligations, then they pay instead. That is it. All the theatrics, involved discussions and details of negotiations to ‘solve’ the debt crisis are simply about who will pay, how much and when.

Second is how conditions for profitable accumulation can be restored. The two classic mechanisms are the destruction of capital values and the increased exploitation of the workforce. Capital values can be destroyed through a collapse in asset and commodity prices. Those capitalists left standing can then buy means of production cheaply. Any new profit extracted is then measured over a smaller capital outlay, raising the rate of profit. A similar effect can be achieved by the political seizure of productive assets in other countries. This can risk conflict between rival powers, but that stopped neither the imperial adventure in Iraq, nor the latest in Libya. The other key mechanism for restoring profitability, increased exploitation of the workforce, is under way already. In many countries, real wages are falling as nominal wages rise less than inflation[6] and as companies impose onerous productivity deals.

Today we see a third important mechanism: the elimination of ‘waste’. By this I mean expenditures that capital can do without - those which do not directly contribute to profitability, either now or in the near future. Why bother educating workers when there are plenty of skilled and educated ones available already? Why bother to provide more than the absolute minimum of health and welfare services? In the public sector that is at the forefront of government spending curbs, a resetting of wages and conditions is under way, as well as cuts in jobs. In the formerly protected professions – both inside and outside state employment – the logic of capital will now aggressively ask: what’s the point of your job? There will be fewer state subsidies and less institutional protection for professional employment, and, ultimately, a proletarianisation of broad sections of the middle class. The latest example of this trend comes from Italy, whose government is coming back early from its summer holiday to implement austerity measures. These include a constitutional change that would force ‘closed professions’ to liberalise services, plus a ‘speeding up of welfare reforms, and other structural reforms designed to boost Italy’s stagnant economy’.[7]

Not many people think that life is easy, or that they are having a great time. But whatever they think now, the logic of the profit crisis demands a new wave of austerity as much as it will bring other forms of destruction in its wake. If the details of the debt piles in different countries are any guide, those living in the richer countries will feel the biggest shock to their living standards. So much more the pity then, that there are no anti-capitalist forces in these countries ready to counter the attack; and so much more the risk that the crisis of capitalism will be blamed on something else.

Tony Norfield, 8 August 2011

[1] Figures calculated from a chart in ‘Mapping global capital markets 2011’, McKinsey Global Institute, August 2011, p2.
[2] See ‘The Real US Debt Problem’, 26 July 2011 on this blog.
[3] In the event, from 2009, the BoE only bought only some £2bn of private sector assets, compared to £198bn of government bonds. However, it has kept interest rates unchanged at 0.5% since March 2009, despite its targeted measure of inflation (CPI at 2%) having been breached every month from December 2009, reaching as high as 4.5% - a negative real interest rate on this measure of 4%!
[4] There is a debate on the size of the ECB’s total exposure to potentially toxic assets, which some argue is in excess of €800bn. For example, see Der Spiegel, ‘Europe's Central Bad Bank’, 6 June 2011, which also notes that the ECB considers as eligible security for collateral a Portuguese bond that matures in roughly 8,000 years on 31 December 9999! The specific numbers in the text above are taken from ECB reports to July. The ECB’s reports do not give many country or asset details of its exposures.
[5] See ‘Anti-Bank Populism in the Imperial Heartland’ 5 July 2011 on this blog for details of the trend in US profitability and its link to the credit boom.
[6] Central banks in the US, UK and Europe are happy to ignore the higher-than-target inflation rates as long as there is no sign that wage growth will respond to the higher cost of living and real wages fall. Signs of rising wage demands were the reason the ECB raised interest rates in April and July this year.
[7] See Financial Times, ‘Italy agrees to liberalise economy’, 5 August 2011.

Saturday 6 August 2011

US Credit Downgrade

Standard & Poor’s downgrade of the US credit rating from the top AAA level on Friday was not a big surprise, but it was nevertheless a historic event. The huge scale of US debts is widely known, and the ratings agencies are not famous for their penetrating insight, so it would be tempting to say: so what? Yet what is happening is that another element of the post-1945 infrastructure is collapsing. For the US it is like being told to travel in business class, rather than first class. Nothing uncomfortable, and still much better service than in the economy seats, but a severe blow to the prestige of the world’s major imperialist power. Already, the US finds that its lecturing of other countries is increasingly dismissed.

The new, lower credit rating from S&P is AA+, while both Moodys and Fitch, the other two key agencies, still maintain their top ratings. Major investors normally take an average of two or three ratings, but Moodys is also considering a downgrade. The decisions are based only partly on the recent shenanigans to avoid default, and more on the huge current debts and the ballooning debts into the future, debts that the US will be increasingly unwilling, or unable, to pay for.

Next week, S&P will make a statement on the (lower) credit ratings of government-backed housing finance agencies, Fannie Mae and Freddie Mac, and there could even be knock on effects later to the debt ratings of US corporations. ADP, Johnson & Johnson, Microsoft and ExxonMobil are currently rated AAA by S&P, but it is very unusual for a corporate to be graded at a level higher than the government. The US Fed has told bankers that Treasuries and other government-backed securities can still be held as capital with a ‘zero risk’ rating, but the global market may be less forgiving. Some investors will only hold AAA-rated securities, and some market operations normally only take top-rated assets as collateral in deals. These effects will undermine America’s privileged status as the benchmark for the global capitalist system.

The full economic impact of the downgrade will take time to become clear, if only because it will be difficult to separate out what is happening as a result of this from what is caused by the general crisis in the global economy. For example, it may not be that US bond interest rates rise immediately. Last week there was a general slump in global equity markets, but US government bond prices rose and yields fell. This is a common pattern as finance flees from one market into another, and something similar could happen again. Nevertheless, over time US interest rates will be higher than they otherwise would have been. This will raise the potential servicing costs of all US debts, from the Treasury’s, to mortgage borrowing, to consumer loans and investment.

The political impact threatens to be more significant, by giving a clearer signal to everyone everywhere that the balance of imperial power in the world is changing. Relative US economic weakness has already made it more difficult for the US to get its way, or for its opinions to be as decisive. Its political weakness and inability to sort out its debt problem now threatens more global financial turmoil. When the US refuses to act, it is trouble for European powers trying to force austerity on their populations.

China is not pleased either. Days before the S&P move, a Chinese rating agency had already downgraded the US: from A+ to just A, with a negative outlook.[1] China's official news agency Xinhua said that it had ‘every right now to demand the United States address its structural debt problems and ensure the safety of China's dollar assets’ (these amount to a reported $1.2 trillion in US Treasuries, and on my estimates another $700bn in other securities). In a cutting comment, Xinhua reported that the ‘US government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone.’ Recent events have also led China to renew its call for an end to the dollar-dominated currency reserve system, another sign that the foundations of US power are slowly crumbling.

Tony Norfield, 6 August 2011

[1] See Xinhua News, ‘Chinese rating agency downgrades US credit rating after debt limit increase’, 3 August 2011.

Thursday 4 August 2011

Pirates of the Caribbean: Sugar & Slavery

Book review: Matthew Parker, The Sugar Barons: Family, Corruption, Empire and War, London: Hutchinson, 2011, 446 pages

Britain was once the world’s biggest slave trader, transporting African slaves to colonies in the Americas. Two-thirds of the slaves worked on sugar plantations in the Caribbean, and this book gives the history of the British families who owned them: the ‘sugar barons’. Parker’s account of the mercantile entrepreneurs who developed plantations in the West Indies is interesting, and he shows that their colossal wealth made the King of England look like he was down on his luck. But more enlightening is his tale of the colonial escapades of Britain and the other European powers in the West Indies of the 17th and 18th centuries. He shows how events were shaped by the growth of the world market, the economics of slave labour on the plantations and the changing balance of power between the dominant countries.

The huge wealth of the sugar barons came from low costs and high revenues. The low costs were based on slave labour imported from Africa to work on the plantations in Jamaica, Barbados, Antigua, etc, and on a climate that was very fertile for the rapid growth of sugar cane. High revenues were helped by sugar being a new luxury product beginning to get a mass market in Europe, and also by the restricted competition in the British empire, enforced by Britain’s naval strength and mercantile trading rules. It was not all easy for the barons, however. Heat, humidity, hurricanes, mosquitoes, disease and disasters took their toll, and a significant proportion of these willing emigrants to the West Indies died within a few years. Another big health hazard for Europeans was their debauchery and drunkenness. Plantation owners would even be plastered at breakfast on claret, Madeira and hock.

The profitable sugar plantations made 18th century Jamaica the ‘best jewel in the British Diadem’, in the words of Admiral George Rodney. This was the period before India had become the ‘jewel in the crown’ of the British empire. Not surprisingly, the economic status of the West Indian islands meant that there were persistent naval clashes, seizures of land and re-annexations between Britain, France, Spain and the Netherlands. Both before and after the 1776 American Declaration of Independence from Britain, America’s Thirteen Colonies also played a key role in these wars. Parker notes how, during America’s war of independence, Britain’s ‘defence of Jamaica was given priority over the war with America’. Jamaica was the more valuable asset.

One fact that strikes the reader who may know little about this period is that unbridled aggression between the major powers was common. Within the boundaries of Europe and the surrounding seas there was more of an attempt to regulate conflict; outside, no holds were barred. In the Caribbean, merchant ships were frequently attacked and looted, but not only by pirates. There were also many ‘privateers’ given explicit endorsement by their states to bring back the booty. Parker notes how 1000 buccaneers operated out of Port Royal in Jamaica in the mid-1600s, working under official sanction from the British authorities to attack the Spanish settlements and ships in the region. Far from Johnny Depp’s Captain Jack Sparrow being one of the outlaw ‘Pirates of the Caribbean’, he was just as likely to be operating under government licence. Even the Royal Navy got involved in the theft. In 1780, the previously mentioned Admiral Rodney looted St Eustatius, an island colonised by the Dutch, and spent three months selling the captured goods!

This was a more obvious link between military power and economic plunder than appears to be the case today. However, the evidence that Shell and BP met the UK Labour trade minister Baroness Symons ahead of the 2003 invasion of Iraq,[1] and the latest British adventures in Libya to control its energy resources, show that there is now just a clearer division of labour between the state and the corporations.

The West Indian sugar barons eventually became absentee owners, preferring to live back in the comfort and safety of Britain on the profits of empire and slavery. They wasted much of their riches building extravagant country estates, but also put a lot of cash into more speculative ventures – some of which turned out to be Britain’s industrial revolution in the late 18th and early 19th centuries! By contrast, the West Indian colonies saw no development. Instead the islands were vulnerable to the problems that came from a monoculture economy determined by the needs of the ‘mother country’. The sugar plantations went into decline as soil fertility diminished and cheaper sources of supply were found elsewhere to supply the growing world sugar market. Only the turmoil in the more productive French sugar producing colonies that followed the French revolution in 1789 – including the later slave revolts led by Toussaint L’Ouverture - gave Britain’s sugar colonies a breathing space as prices rose again.

Parker’s book briefly covers the long period of agitation in Britain against the slave trade, ahead of the passing of the Slave Trade Act in 1808. As one antidote to British hypocrisy and smugness on this issue (although he does not call it so), he notes that individual US states had already begun banning the slave trade more than 20 years earlier than Britain. However, he does not pay enough attention to the economic factors behind this British decision, and the much later move to abolish slavery itself in the British empire in 1838 (with generous compensation to the slave owners, of course). His account does provide interesting details of the impact on the sugar baron families and their political connections - the main subject of his book. But a more fundamental analysis of the role of slavery in the mercantile form of capitalism and its decline with the growth of industrial capitalism is given by Eric Williams’s classic text, Capitalism and Slavery.[2] Williams shows how the progressively less attractive economics of slavery for British capitalism was behind parliament’s move to ban the trade and, only later, the institution itself. It was because the economic changes took many years to work themselves out that the moral arguments of the anti-slavery movement were irrelevant for so long.[3]

One feature of the book that concerns me is that it is prone to include phrases of regret when discussing Britain’s colonial adventures. This is despite its detailed documentation of the many crimes committed by Britain and other powers, including ‘the invention of ever more brutal tortures’ of disobedient or unruly slaves.[4] For example, Parker says ‘the unhappy precedent of Hispaniola [a previous failed offensive] asserted itself’ when the British had to abandon an attack on a Spanish colonial city (p253).[5] Why use the phrase ‘unhappy precedent’, unless one hoped that it had not been a defeat for the British? It would make more sense just to explain what happened. Perhaps Parker is just being sarcastic. But this kind of phrase is found in the writings of many who look upon their country’s depredations as casting a bad light on what, at heart, is a decent country worth defending. Nevertheless, The Sugar Barons is well worth reading to get a good idea of the state of the world before the emergence of industrial capitalism and imperialism.

Tony Norfield, 4 August 2011

Addendum, 24 September 2013: A reader of the above review points out that many Irish slaves (or 'indentured labourers') were also sent from Ireland to the Caribbean by British 'transportation' policies. This was not covered in my review, nor in the book, but the numbers involved were significant. For further information, check out Wikipedia or an article here.

[1] Paul Bignell, ‘Secret memos expose link between oil firms and invasion of Iraq’, The Independent, 19 April 2011.
[2] Eric Williams, Capitalism and Slavery, University of North Carolina Press, 1994 (originally published in 1944).
[3] For a useful review of the modern version of slavery, see Kevin Bales, Understanding Global Slavery, University of California Press, 2005. Today’s slavery is bound up with the news stories of ‘human trafficking’ and is principally a result of bonded labour, resulting from debts owed to landlords and moneylenders in poor countries. Today there are reported to be around 27 million bonded labourers and other forms of slave working in countries all over the world, including in the richer countries.
[4] Karl Marx was referring to such behaviour when he wrote that “Jamaican history is characteristic of the beastliness of the true Englishman”, a comment that Parker notes in his book.
[5] Hispaniola was the name of the major island in the Caribbean now containing the Dominican Republic and Haiti. The island had been fought over by major European powers, and was divided up mainly between France and Spain.

Tuesday 2 August 2011

Foxconn & the Organic Composition of Capital

“Foxconn, the world’s largest contract electronics manufacturer by revenue, plans to increase the use of robots in its factories 100-fold to 1m within three years, according to Terry Gou, chairman and chief executive.” (Financial Times, 1 August 2011)

Taiwanese company Foxconn has already made an appearance on this blog. Last time it was to give an example of how the exploitation of Chinese workers helps boost the profits of foreign companies.[1] Here it is to illustrate what Marx called the rising ‘organic composition’ of capital.

Marx’s theory of value analyses the form that social labour takes when workers have to sell their labour-power to capitalists,[2], the owners of the means of production. The sole motive for capitalist production is profit, and this is derived from workers receiving less value for hiring out their labour than they add to the value of the product when working. Competition forces capitalists to raise productivity in order to cut costs. But raising productivity means more things are made per worker in a given time, so this will increase the mass of means of production (raw materials, machinery, etc) compared to the number of workers employed and the labour they perform. Alongside this rise in what Marx called the ‘technical composition’ of capital, the value of the means of production will also tend to increase relative to the amount of the wage bill. The concept of the rising ‘organic composition’ of capital is used to refer to the process of capital accumulation where both the technical and the value compositions rise together.[3]

This combined ‘organic’ concept of the composition of capital is critical for understanding what happens to capitalist profitability. While the number of hours of surplus-labour determines the amount of the profit, the rate of profit is measured by this amount divided by the value of the total capital invested. Take the example of a typical worker. There is a limit to the amount of surplus-labour that can be performed which is set by the total working day. Yet there is no definite limit to the mass of raw materials and machinery that he or she can work with. So, over time, there is a tendency for the rate of profit to fall per worker, and in general across the capitalist economy. This is because the mass of profit will tend not to rise as much as the value of the capital invested in means of production. As the rate of profit falls, the system becomes more prone to crises. Marx’s theory shows how capitalism places limits on increasing productivity and is a barrier to social progress.[4]

Of course, there are many factors that affect how this trend works out in reality. It can be misleading to focus on particular examples, but Foxconn’s investment plans clearly show this dynamic at work. This company runs huge factories employing a total of a million workers in China alone. If its decisions are exceptional, it is only in their magnitude. The Financial Times report cited above gives the following details:[5]

·       Foxconn currently uses just 10,000 robots, below the normal level expected. The number of robots will increase to 300,000 next year and to 1 million in three years. This is a response both to the need to increase productivity and to the higher wages that Foxconn is forced to pay due to labour shortages, adverse publicity from the suicides of workers at its plants, etc.
·       Wages for the poorest paid (migrant) workers rose by 30-40 per cent last year and are expected to increase by another 20-30 per cent annually until at least 2013 (though this would still leave wages at barely a quarter of those in the US). This is in addition to an expansion of the workforce by several hundred thousand.

No further details were given in the FT report, but it can be estimated that while the company’s wage bill could rise by a factor of 3 in the next few years (higher wages and more workers), the number of robots will increase by a factor of 100. Other elements of the means of production may not increase by anything like as much as the extra cost of the robots, but the total investment in means of production could easily rise by a factor of 10. That would definitely increase the ‘organic composition’ of capital.

The impact of the investment on Foxconn’s profitability remains to be seen. Companies that innovate usually gain a competitive advantage that can boost profits for a while, until others do likewise. But Foxconn is subordinate to the demands of powerful companies like Apple, Dell, SonyEricsson, Nokia and others, so this is less guaranteed. Foxconn actually reported a loss of $220m in 2010, after only a small profit in 2009. This may be creative accounting as much as reality, since Taiwan’s Foxconn International Holdings is incorporated in the Cayman Islands!

Foxconn appears to be shifting away from brutal worker exploitation, based on long hours, terrible conditions and minimal pay, to a strategy that depends more on boosting productivity with further huge capital investments. Details are difficult to get, but one report indicated a $2bn investment in a new factory in China, which gives an idea of the scale of Foxconn’s operations.[6] The end result is a rising organic composition of capital.

Tony Norfield, 2 August 2011

[1] See ‘What the “China price” Really Means’, 4 June 2011.
[2] The theory of value is a theory of the social organisation of labour under capitalism, extending to an analysis of the forms and dynamic of the system, including the theory of crisis.
[3] Marx introduces this concept in Chapter 25, ‘The general law of capitalist accumulation’, of Volume 1 of Capital. In Volume 3 he develops the analysis to explain the trend in the rate of profit and crisis.
[4] It is important to recognise that the limit to increasing productivity here is a capitalist-determined limit that comes from declining profitability. This is not a limit that comes from technological barriers on how far productivity might be raised.
[5] The bullet points are my interpolations from the article, based on other reports. The link to the FT article is:
[6] Bloomberg News, ‘Foxconn to Invest $2 Billion in New China Plant, Xinhua Reports’, 22 October 2010.

Monday 1 August 2011

Tea Party Antecedents

The US ‘Tea Party’ takes its name from the famous ‘Boston Tea Party’ of 1773, when hundreds of crates of Indian tea on British ships were dumped into Boston harbour by American colonial rebels. However, a common misunderstanding is that this event was a protest about high taxes. It was not. The reason for the anger was that the British had actually cut the tax on imported tea. This meant that American smugglers and merchants dealing in tea supplied by Dutch ships were going to be put out of business because their product would soon be selling at a higher price than the new imports of Indian tea!

It is true that the American settlers were also indignant about rules being changed without consulting them – ‘no taxation without representation’ - and about to whom the British would give legal rights for importing tea. Yet the relevant point is that the claimed forebears of today’s ‘Tea Party’ in the US Congress were smugglers and dealers threatened by changes in the global economy. It is this that makes the name more apt than its members will realise.

Back in the late 18th century, history was on their side. Today’s tide of reaction will find success much more elusive as the US struggles over its own bankruptcy.[1]

Tony Norfield, 1 August 2011

[1] See ‘The Real US Debt Crisis’, 26 July 2011 on this blog for details. The article ‘Anti-Bank Populism’, 5 July 2011, also explains how the build up of debt was due to the crisis of low profitability.