Michael Meacher - Labour's Future

With the latest action on Bear Stearns the most serious financial news yet, it is not too soon to envisage a new era.

The quarter century dominance of Keynesianism was overturned by the oil price-induced hyper-inflation of the 1970s, which paved the way initially for the rise of monetarism and thence the quarter century ascendancy of the Washington neo-liberal consensus. The sub-prime housing fiasco and the subsequent banking credit crunch, the results of which are still being felt across the international economy, are now bringing this period of hegemony to a close, not only because of western banks having to be bailed out by sovereign funds from China, Asia and the Middle East, but mainly because of systemic failure which is at risk of precipitating collapse.

The problems go far deeper than the demise of Northern Rock or the activities of a single rogue trader at Societe Generale. These were dealt with by the authorities as though they were isolated aberrations of a basically sound financial system, by trying in the former case to manipulate an alternative private takeover and in the latter to tighten the internal trader rules. This is like taping the fences to hold back the tsunami. The Treasury's recent proposals to allow the Bank of England to carry out secret rescue operations or the Financial Services Authority to seize the deposits of savers if a bank is in trouble, are scarcely any more useful. All these measures simply do not recognise the scale of the challenge that now confronts financial markets.

The whole nature of the global financial system has altered drastically in ways that the International Monetary Fund (IMF) can no longer control. The investment managers of private equity funds and major banks have displaced national banks and international bodies and extended their power far outside existing regulatory structures by "reintermediating" themselves between national and individual traditional borrowers on the one hand and the markets on the other. They have deregulated the world financial structure, making it far more unpredictable and liable to crises. Their business is to generate out-of-the-ordinary investment returns, which governs their reward, and it drives them to take ever-mounting risks.

It is ironic that the deregulation and liberalisation, which the IMF and the Washington consensus advocates championed so aggressively through the last three decades, have now spiralled out of control. That is the result of a conjunction of factors which has created hugely greater risk than they ever conceived. One is the entwining with the US fiscal and trade deficit which is still rising fast. The Bush administration has added over $4tn to the federal borrowing limit, which now stands at $9.8tn. The continuing devaluation of the US dollar has then driven banks and funds to see increasing financial risktaking as worthwhile.

Second is the rise of hedge funds, which now control assets worth $1.5tn worldwide, with the top 10 alone controlling $250bn. They are often highly profitable, but at the same time increasingly dangerous. Their reward structure encourages recklessness: the 26 leading hedge fund managers in 2005 earned on average $363m each. Altogether, hedge fund managers in the City and Wall Street took home $50bn last year. They depend on a constantly rising stock market, and current conditions expose their fragility. Even the Long-Term Capital Management hedge fund meltdown in 1998 showed that banks simply do not understand the chain of exposure, yet today the financial network is much larger and more complex.

Third, hedge funds now deal in credit derivatives and a variety of other arcane financial instruments. The credit derivative market barely existed in 2001, and grew quite slowly until 2004, when it really took off, exceeding $17tn by the end of 2005. Their sheer complexity was designed partly to prevent their being copied, but mainly to package a seemingly attractive product which could generate enormous short-term gains. The downside, ignored while profits remained high, was the potential for unleashing a chain reaction of losses that could engulf the hedge funds that had jumped on the bandwagon. In the event the sub-prime market debacle provided the trigger. However, other devices, even more opaque, such as split capital trusts, collateralised debt obligations and market credit default swaps, have caused the IMF and senior financial regulators even more worry.

As these risks and problems have mounted inexorably, the IMF has undergone a structural and ideological crisis. Its outstanding credit and loans diminished sharply from $70bn in 2003 to less than $20bn now, drastically cutting its leverage over economic policy across the world. It is now actually in deficit. This trend has become even more pronounced as developing countries, mainly China provide even more foreign direct investment in other developing nations. That has now been extended further by the partial takeover of the western banking system - Citigroup, Barclays, UBS to name but a few - by Arab and Asian governments.

There are at least two other sides to this financial maelstrom. Both are again structural. One is the greatly increasing ratio of corporate debt loads to core earnings. Whilst interest rates remained low, leveraged loans provided a solution for firms that should have gone bankrupt, and now too often incompetent, debt-ridden firms find a market with hedge funds and other financial instruments. Another issue is that the speed and complexity of the deregulated market has generated widespread errors on a disturbing scale. The International Swaps and Derivatives Association recently found that 20% of deals, many involving billions of dollars, were subject to major errors.

The dangers that all these factors are exposing are slowly accumulating. The ticking time-bomb in the US banking system is not resetting sub-prime mortgage rates; it is the contractual ability of investors in mortgagee bonds to require banks to buy back the loans at face value - at present almost 10 times their market worth. In the UK the contagion affecting the banks is beginning to seep into other areas, notably the monoline insurers (who provide the insurance for bonds), and could well threaten the market for credit default swaps which, given its size - $45tn - could prove catastrophic.

The central banking and governmental response to the crisis - showering unlimited liquidity and huge tax cuts onto the markets - is no solution if, quite apart from exacerbating moral hazard, it leads to higher inflation, a falling dollar and higher long-term interest rates. On the other hand, for the authorities to be blackmailed into saving the current international financial structure at any price is simply to invite the next crisis, only sooner and worse. If we are to escape this situation being repeated again and again, what is needed is a frank recognition, however painful, that self-regulation has failed spectacularly and that a new system of international financial governance is now urgently needed in which the re-regulation of banking must be the least requirement if government and taxpayers are to be expected to guarantee deposits.