The current financial crisis in the United States (US) is developing into a free fall fall-out of financial giants. So far, Wall Street has experienced an unbelievable fall-out of stars, who were all blue-chip investment brokers, business and household names of solid financial stability. The falling stars include Lehman Brothers, Bear Stearns, Morgan Stanley, Goldman Sachs and Merrill Lynch. Several other collapsing high-profile financial houses were bought by stronger companies and subsumed into their operations.

Moving to the most sensitive arm of the financial system, bank collapses are also part of the meltdown. One of the American top banks with a global spread to 100 countries, Citigroup, unbelievably faces financial collapse without a Government bail-out of US$20 billion, in addition to a US$25-billion injection provided, last month, and a guarantee of US$306-billion of weak loans and securities now being finalised.

The insurance giant AIG has not escaped the crash. It had to be bailed out by the US Government with an injection of US$122.8 billion, plus additional support which will bring the total to around US$150 billion.

Not to be omitted, the giant automobile industry is also facing collapse. General Motors and Ford Motor Company, the big two, are pleading to the US Congress for help. Some US$25 billion is needed now or General Motors will crash by Christmas.

stock market investments

On September 7, Freddie Mac and Fannie Mae, the giant mortgage financing institutions, were placed under the conservatorship of the Federal Housing Finance Agency (FHFA) - this caused the issuance of new senior preferred stock to the US Treasury and warrants to purchase common stock amounting to 79.9 per cent in each entity.

All these failing financial giants have impacted on confidence in stock-market investments, plunging volume and value traded to the lowest levels in decades. In fact, the nine-per-cent fall in the market this quarter is the worst since 1947. The wipe-out of business assets has reduced General Motors share value to US$2 per share, just to cite a case of the unbelievable.

According to President George W. Bush, there are more bail-outs to come. Certainly, suppliers to the automobile industry, like aluminium and steel producers will feel the crash if the car industry is not bailed out.

financial disasters

What is the cost of the bail-outs already committed by government and projected to support further expectations? Some US$8 trillion, it is expected, will be required. This stupendous sum is some 60 per cent of the gross domestic product (GDP) of the US and the end is not yet in sight. If the damage holds at that level, the overall cost of this free-falling fall-out in the US eco-nomy would be the worse disaster, exceeding Argentina, which lost 55 per cent of its GDP in 2001. Next in line among the worse financial disasters was Indonesia, 45 per cent of GDP and Jamaica 40 per cent.

Comparing this meltdown with the Great Depression of 1929-1933 is revealing.

The stock market is reflecting the uncertainties of the times with a massive wipe-out of stock values across the globe. It was the crash of the stock market in 1929 that precipitated the Great Depression, wiping out 50 per cent of the national income of the US and plunging unemployment to 24.7 per cent, down from 3.1 per cent. Professor Steve Hanke who provides these figures in his monthly newsletter, Perspective, reminds that the US did not recover pre-Great Depression level in trade until the early 1970s (just in time for the next crash created by the overnight tripling of the price for a barrel of oil). Economic prospects became so dismal that, "more people were immigrating than emigrating", (that is, leaving the country than entering) Hanke observed. This picture reveals that today's crisis conditions, although the most serious since 1929, are still some distance away from creating the Great Depression of 1929-33 when 90 per cent of the stock market was wiped out. But this crisis has its own unique conditions which did not exist in 1929-33.

The takeover of United States mortgage giants Fannie Mae and Freddie Mac places enormous power in the hands of a new regulator, the Federal Housing Finance Agency. - AP

market economy

The frequency of financial crises and economic depressions beg for a solution to prevent a recurrence. With the market economy, this is most unlikely because of the multiple decisions which are required by multiple countries all expected to work in concert to keep the system stable, but at critical times unable to do so. This difficulty is particularly true with the advent of globalisation, which has maximised free-flowing trade and finance by removing global impediments. But, by understanding the weaknesses in the global system, the fall-out can be minimised. The solution, then, is to find the weak links in the chain as the globalised-market system moves through the process of investment - production - trade - profit - savings - investment.

A convenient starting point is the substantial surge in economies with spectacular growth, particularly China, which has produced robust growth rates annually for the last 15 and more years. The Chinese mega-output of 9-10 per cent per annum growth has been replicated in India and, more recently, Brazil and Russia are showing consistently strong annual rates of growth.

This virtually unprecedented sustained robust economic output has created surplus earnings, which must be invested rather than remain idle earning nothing. The investment vehicles for these stimulating performers are huge sove-reign funds. While some of the bulging surpluses are invested in projects, the choice investments are American securities, principally US government bonds. China at present holds $700 billion dollars in US Government securities.

investment outlets

The American banking system and investment houses, as well as the United Kingdom counterparts, have to find investment outlets for the available heavy inflows of funds seeking dollar and sterling investments. But, there is a limit of prime investment outlets available. The excess, therefore, has to settle for subprime investments, which have little or no security to offer. The choice here was housing mortgages, in the belief that if mortgage financing were offered to new home purchasers who were poor they would make the extra effort to keep up the payments.

It is in this scenario of a dangerously inflated bubble of high-risk mortgages that the balloon was deflated overnight leaving trillions of dollars of poorly secured, high-risk or unsecured loans. These loans were traded in the secondary-mortgage market globally, by packaging high-risk mortgages with low-risk and no-risk securities. These packages were readily accepted as investments worldwide.

The pin that pricked the balloon was the run-away increase in oil prices and commodity prices linked to excessive production of corn for ethanol in America, creating a shortage of other food items, particularly cereals. This shortage translated into higher prices.

spiralling prices

American consumers and others who were caught in the global net of spiralling prices had a crucial choice to make: either less food or other essentials so as to continue to pay the mortgage, or to ensure their purchasing power for food and other critical demands by not making mortgage payments. They chose to allow the homes they could not afford, to be foreclosed by the lenders. Trillions of dollars were lost by the subprime loans, engineered principally by the collapsing Fannie Mae and Freddie Mac, the two mortgage giants whose loan portfolios had to be taken over by the US Government. The subprime mortgage collapse was the virus that spread around the world.

The damage is working its way through the system.

The bigger issue is not when, but will the system return eventually to what existed before?

The answer to this question lies in recognising that surplus earnings from robust production in BRIC (Brazil, Russia, India and China) countries, and others, will continue even if with less growth for a few years. Hence, excess liquidity will still be a factor, a situation with which previous recessions did not have to deal. This will be so primarily because the banking system will be fearful for sometime to come in granting new loans, given the near collapse experience. This is already happening. Hence, there is a credit choke in the system for loans to consumers and investors, which Washington is now endeavouring to relieve.

Given the sustained growth in liquidity, the global financial network now has an unprecedented challenge to find sufficient secure investment outlets. The experience of the past several months, and perhaps earlier, has shown that the secure investment markets of the industrial countries (OECD) are only a partial outlet. What this means is that new investment outlets which can be secured must come from emerging countries where vast infrastructure needs exist.

global financial centres

In this case, a vastly expanded World Bank and its subsidiary, the private sector lending arm, the IFC, (International Finance Corporation), will have to take on considerably more lending. Wall Street and other global financial centres would have to expand their scope as the intermediary conduit to the World Bank (also Inter-American, Asian and African counterparts) to provide the huge funding that could be available to programme and project development in needy countries. These multilateral banks are the best vehicles to deal with this mega-challenge.

High-growth countries can also reduce some of the damaging surplus liquidity by spending more of these reserves to build up their own countries. China, appropriately, announced a US$700-billion plan to create infrastructure funding for projects in China.

It is an ironic twist of fate that what is involved at the bottom-line would be a bypassing of traditional funders as the dynamic of development shifts from the OECD (industrial) countries to the more dynamic emerging nations of the South. The World Bank would then have to be restructured to seat on its board a heavier weighting of these new players while the traditionalists watch the game in play.

Edward Seaga is a former prime minister. He is now a Distinguished Fellow at the University of the West Indies. E-mail: odf@uwimona.edu.jm. or columns@gleanerjm.com