Since the late U.S. President Ronald Reagan came to power in 1980, U.S. capitalism has shone for three decades until recently, demolishing socialism in 1989 and ruling the global financial market and economy.
Leaving the glory years behind, U.S. or neo-liberal finance capitalism, is facing its demise or at least a major overhaul, due to the Wall Street crisis caused by the collapse of giant American investment banks, the icon of this form of capitalism.
Many argue that the demise of the banks is not the end of capitalism characterized by ``small government'' and ``deregulation,'' but its doom is inevitable as every passing day brings worse news.
Financial crises in Asia and Mexico have consumed the credibility of capitalism but no one then cast a serious doubt about it. However this time is different becasuse this meltdown happened on Wall Street, its very heart.
The U.S. has passed the point of no return by stepping heavily into the market, negating the fundamental principle of capitalism, ``laissez faire,'' French for ``let do'' and meaning that the government leaves people alone regarding all economic activities.
The burst of the property bubble and the demise of U.S. investment banks have exposed inherent flaws, forcing Washington to fix its financial system with public money and to find ways to keep its markets afloat.
In the last weekly report under Lehman Brothers banner, chief economist Paul Sheard said, ``The current crisis seems to transcend the usual pattern of asset price boom and bust, damaging balance sheets and threatening the stability of the financial system and the health of the economy.
``The severe impairment of the originate-to-distribute securitization model and the demise of the standalone investment bank are starting to look more structural than cyclical.''
Regardless of the outcome of the U.S. government's bailout plan, the Wall Street crisis is expected to transform U.S. capitalism into a ``more regulated'' and ``less profitable'' form, replacing its investment banking saga with universal banking ― a cocktail of commercial and investment banking.
What went wrong in the US?
Under the ``laissez faire'' economic liberalism, an economic system that espouses minimum government intervention, maximum competition and free flow of capital, the U.S. economy thrived for 30 years but two big mistakes were made. The government de-regulated finance too much, while encouraging unsustainable debt-financed consumption.
The collapse of giant U.S. investment banks is the outcome of these mistakes. Lehman filed for bankruptcy and Merrill Lynch was taken over by the Bank of America. Goldman Sachs and Morgan Stanley are poised to become regulated banks as the Federal Reserve approved their applications to become bank holding companies.
What made the investment banks face a forced exit from the market? How could a financial system once touted as the most sophisticated in the world fall into a debacle so suddenly? Lax monetary policy, the illusion of financial innovations and excess deregulation were the three culprits behind the fall of Wall Street.
Greenspan's lax monetary policy was the root cause for the current Wall Street crisis as it triggered excessive borrowing for property purchases, creating a real estate bubble.
``The common problem across much of the crisis has been excessive leverage,'' Mauro F. Guillen, director of the Lauder Institute at the Wharton School of Business told The Korea Times.
``Pressured by investors, many banks and investment houses borrowed heavily to multiply their client's returns,'' he added. ``Their exposure is 30 to 40 times their capital base, meaning that both gains and losses are multiplied many times over.''
When the U.S. economy was slipping into recession following the burst of IT bubble, the Federal Reserve relied on loose monetary policy to keep the economy afloat. Greenspan cut key rates by a total of 5.5 percentage points between 2001 and 2004.
Capitalizing on low interest rates, many households rushed to borrow to purchase homes and land, which led to surging property prices, causing asset inflation.
Andy Xie, an independent economist and former Morgan Stanley chief economist, said that Greenspan's lax monetary policy led other central banks to keep monetary policy equally loose to prevent appreciation of their currencies.
``Through the currency market Greenspan was effectively setting monetary policy for the world. Not only the U.S., the whole world should blame him for the catastrophe today,'' he added.
Financial innovations made market participants believe that they could reduce the risks to zero by diversifying the risks through securitization, which encouraged banks to borrow heavily to multiply their clients' returns.
Xie said that financial innovations in recent years purported to decrease risks to credit investors, which allowed less capital and more debt for property purchases.
``As it turns out, the risk reduction from financial innovations was an illusion. The perceived reduction in risk was due to the bubble that the belief in risk reduction caused,'' he added.
With the high home prices and low interest rates, hundreds of billion of dollars of mortgages were extended and these were then bundled together in financial investments known as mortgage-backed securities, the epicenter of the subprime mortgage crisis.
With the development of mortgage securitization, the role of financial innovations expanded and credit derivatives became more complicated, making bankers miscalculate the risk of those securities.
``The development of collateralized securities provided a big push for the creation of subprime loans, which could now be bundled, spreading risk,'' Peterson Institute senior research fellow Marcus Noland said.
``But this also had the effect of greatly reducing the risk aversion of the originators of the loans since they were selling them and no longer bearing the risk,'' he added. ``The result was a predictable decline in quality and eventually criminal behavior on the margins.''
With the manufacturing industry drying up, the United States focused on expanding its financial sector through deregulation. The deregulation drive generated the so-called shadow banking system, a secret network built on derivatives and untouched by regulation.
Under the system, non-bank financial firms borrowed short and in liquid forms and lent or invested long in more illiquid assets via the use of credit derivative instruments, which allowed them to evade normal banking regulations.
This system, which has been blamed for aggravating the subprime mortgage crisis, served as momentum that allowed the U.S. financial sector to grow bigger and bigger before becoming out of control, outgrowing the real economy.
``The deregulation of financial markets in the late 1970s encouraged the creation of the `shadow banking system' of non-bank entities such as hedge funds,'' Noland of the Peterson Institute said.
``Besides, the financial market deregulation also encouraged the development of complex derivative instruments that were very hard to price since they embody so many contingencies,'' he added
Lessons from Crisis
The U.S. rescue package may help avoid the worst but it cannot solve the fundamental problem behind the crisis. In order to solve the issue going forward, restoring financial sector regulations will be the first step.
Also, market participants should not have overconfidence in financial innovations as these made them focus too much on maximization of returns, overlooking systematic risk that such innovations created.
Stijn Van Nieuwerbur, Stern School of Business at New York University, said that the problem of the mortgage and banking crisis is a standard externality issue.
``Everybody acted individually rationally in the process of originating, securitizing, and selling these contracts, but nobody took into account the systematic risk that this process created,'' he said.
``Regulators should force banks to hold a fraction of these securities on the books instead of selling them off or holding them off the balance sheet,'' he said. ``Also, transparency should be secured in how much of each type of asset each firm is holding and how the book value of these assets is calculated.''
Many argue that the Wall Street crisis triggered by the demise of American investment banks could bring an end to U.S. neo-liberal capitalism. However, global market experts countered that argument, claiming that it is not dead but mutating into a new form.
Policymakers and regulators are now desperate to find ways to keep the financial system afloat through regulatory reform. The look of the financial markets is expected to change toward ``bigger government'' and ``more regulation'' going forward.
``I see a smaller, more regulated, and less profitable finance sector re-emerge over the next two-three years,'' Nieuwerbur of New York University said.
This is well manifested in Morgan and Goldman's move to transform into a bank holding company, which will usher the global financial economy into a new era.
``Commercial banks like JP Morgan Chase, Bank of America or Barclays are now buying some of the distressed investment banks,'' Guillen of the Wharton School said.
Commercial banks have a deposit base, meaning that they have more capital available for investment. They do not need to leverage themselves so much
``We are entering a new era in which universal banks ― those combining investment and commercial activities ― will rule the global financial economy,'' he added.