The Myth of the “Sub-prime” Crisis Prabhat Patnaik

Capitalism, like the proverbial horse, kicks even when in decline. Even as the current crisis hit it, it gave an ideological kick by attributing the crisis to “sub-prime” lending; and so well-directed was its kick that the whole world ended up calling it the “sub-prime crisis”.

The idea, bought even in progressive circles, was that in the euphoria of the boom that had preceded the crisis, financial institutions in the U.S. had given loans even to sections of the population who were not really “credit-worthy”, i.e. who were poor and had few assets of their own. They would normally not get loans from banks; they were not “prime borrowers”. They got loans only because the boom had lowered guards everywhere and banks had started underestimating risks. But if you give loans to people who are not “creditworthy”, who are not “true blue”, then you inevitably come to grief, which is what ultimately happened, precipitating the crisis.

Remarkably, the idea appealed not only to the Right but even to sections of the Left. Sections of the Left liked it because they read into this explanation a basic contradiction of the system: to keep the boom going the capitalist system needs to give more and more loans, and therefore to bring an ever larger number of people into the ambit of borrowing, so that the level of aggregate demand is kept suitably up. This necessarily means that “sub-prime” borrowers have to be brought in more and more for the sustenance of the boom, which therefore must eventually lead to a collapse. The Right saw in it an opportunity to argue that the crisis arose because capitalism had become “too soft”: people who should not be touched by financial institutions with a bargepole had actually been given huge loans. The problem therefore lay not with the system as such, since it normally would never do such silly things, but with an aberration it had suddenly got afflicted with. Some even saw in this aberration a muddle-headed humaneness which the system had suddenly developed. And they used the crisis as an illustration of the fact that all such humaneness is fundamentally misplaced, that there is, as they had always maintained, no scope for sentiment in the harsh world of economics.

In India, apologists of neo-liberalism worked overtime to use the fact of the crisis itself to discredit policies of “social banking”, such as priority sector lending and differential interest rates, that the country had embarked on after bank nationalization. All such policies, they argued, saddle banks with the responsibility of lending to “sub-prime” borrowers, and hence put on their shoulders an unbearable burden of “non-performing assets”. This ultimately makes them unviable and in need of substantial doses of government assistance to survive, as had happened in the US and elsewhere. The moral of the story therefore was that in countries like India the markets should be left to work in their own pitiless manner without having to accommodate sentimental hogwash like “social banking” and “financial inclusion”. Hence by a curious irony, a crisis precipitated in the advanced capitalist world by the free functioning of the markets was used in the Indian context to argue for an unleashing of the free functioning of the markets.

The basic argument about “sub-prime” lending causing the crisis however was a flawed one. The banks had given loans to the so-called “sub-prime borrowers” against the security of the houses they had bought with these loans. If the values of the houses collapsed then banks’ asset values collapsed relative to their liabilities, precipitating a financial crisis. The cause of the crisis therefore lay not in the identity of the borrowers, the fact of their being “sub-prime”, but in the collapse of the asset values, which in turn was because asset markets in a capitalist economy are dominated by speculators whose behaviour produces asset-price bubbles that are prone to collapse. Indeed when the banks were giving loans against houses to the so-called “sub-prime borrowers”, they too were essentially speculating in the asset markets, using the “sub-prime borrowers” only as instruments, or as mere intermediaries in the process.

To attribute the crisis to sub-prime lending therefore amounted to shifting attention from the immanent nature of the system, the fact that it is characterized by asset markets, which are intrinsically prone to being dominated by speculators whose behaviour produces asset-price bubbles that necessarily must collapse, to a mere aberration, a misjudgement on the part of the financial institutions that made them lend to the “wrong people”. It was a deft ideological manoeuvre. The identity of the people who borrowed, whether they were in rags or drove limousines, was actually irrelevant to the cause of the crisis, but it was presented as the cause. The blame for the crisis was put falsely on “sub-prime lending”; and a fabrication, a complete myth, called the “sub-prime crisis” was sold to the world, quite successfully.

Let us for a moment imagine that no loans were made to the so-called “sub-prime” borrowers, and that all loans were made only to “prime borrowers” against the security of the houses that were purchased through such loans. True, “prime borrowers” might not have been interested in taking more loans than they already had, in order to purchase houses, and that “sub-prime” borrowers had to be brought in. But, let us, just for a moment, assume that all the loans that the banks had actually made were made to “prime borrowers” rather than “sub-prime borrowers”. With the collapse in house prices, which had to happen sooner or later, the “prime borrowers” would have found their balance sheets going into the red, and so would the banks who gave them the loans. The borrowers would have been hard put to keep to their payments commitments, and the same denouement that unfolded with “sub-prime borrowers” would have unfolded with “prime borrowers”. The fact that the latter owned other assets would not have made any difference; they would not have easily or voluntarily liquidated those assets to pay the banks for the housing loans (and, besides, those other asset prices too would have collapsed if the prime borrowers had tried to liquidate them). And if such forced liquidation was insisted upon for paying off housing debt, then there would have been prolonged court battles to prevent it; the crisis certainly would not have been averted. Hence the real reason for the crisis lies in the collapse of the house price-bubble (which was bound to happen no matter what the identity of the borrowers), and not the identity of the borrowers themselves.

Of course it may be argued that with consumer credit the matter is entirely different, since such credit has been given to large sections of the population without any security. In other words, it may be argued that consumer credit to “sub-prime borrowers” is necessarily crisis-causing, in a sense that consumer credit to “prime borrowers” is not, since it is given without any collateral. But the consumer credit bubble has not yet busted; so it is idle to speculate on this matter. The fact remains that with regard to the bubble that has actually busted, namely the housing bubble, the identity of the borrowers, whether they are prime borrowers or sub-prime borrowers makes little difference.

To say this is not necessarily to deny that the sustenance of boom under capitalism may require bringing more and more people under the ambit of borrowing, including the so-called “sub-prime” borrowers who normally do not have access to credit. But this is not the cause of the crisis; the bringing in of “sub-prime” borrowers, the widening of the circle of borrowers, is merely the mechanism through which speculation may empirically play itself out. It may be merely a constituent empirical element in the formation of “bubbles”. The real cause of the crisis however lies in these “bubbles” themselves, i.e. in the fundamental fact that in a modern capitalist economy, where fiscal deficits are sought to be restricted, booms are necessarily “bubbles-led” or at least “bubbles-sustained”; and the inevitable collapse of these “bubbles” necessarily produces crises.

Or putting it differently, if “sub-prime” lending had not happened, then the crisis would have occurred even earlier than it did, i.e. the bubble would have collapsed even earlier. This would of course have limited the size of the collapse relative to the top of the boom, since the bubble would have burst before it became too big; but by the same token it would also have limited the size of the boom itself that preceded the collapse, so that the unemployment rate, experienced with the crisis, would not have differed much between the two situations.

A modern capitalist economy is characterized by highly-developed and highly-complex asset markets, where it is not only the physical assets themselves, but, above all, financial assets, which represent claims on physical assets, are bought and sold. Since the carrying costs of these financial assets are extremely low (rats do not eat them up as they eat up foodgrains for instance, and they do not need godowns for storage and for protection from the elements), they are particularly prone to speculation. Their markets tend to be dominated by speculators who buy assets not “for keeps” but for selling soon to realize capital gains. The prices of these assets therefore are determined largely by the behaviour of speculators. When there is a rise in their prices for whatever reason, speculators often rush in expecting a further rise and this pushes up prices even further. This process may go on for sometime creating a “bubble”. But when, for whatever reason, the price rise comes to a halt, speculators start running away from this asset like rats deserting a sinking ship and the “bubble” collapses.

The real point however is this: the amount of the physical asset that is produced depends upon the price of the claims upon it, i.e. of the financial assets that represent claims upon this physical asset. If the price of these claims is high, then more of such physical assets are produced, and if the price is low then less. But while the price of these claims is determined by the behaviour of the speculators, the output and employment in the real economy is determined by the amount of physical assets that are produced. Hence in a modern capitalist economy, it is the caprices of a bunch of speculators that determines the real living conditions of millions of people, their employment and incomes. When speculators are bidding up the prices of assets (or claims upon assets) employment and output start rising and we have a boom. When speculators leave assets like rats leaving a sinking ship and wish only to hold money (and in extreme cases, when confidence in banks gets impaired, only currency), we have a crisis.

John Maynard Keynes, acutely aware of the irrationality of this system that made the lives of millions of people dependent upon the caprices of a bunch of speculators, and yet extremely keen to prevent its transcendence by socialism, sought to alter this state of affairs by advocating “socialization of investment”. This would mean that how much of physical assets were produced depended not upon the whims of speculators but upon the decisions of the State, which made these decisions with the objective of keeping the economy close to full employment.

The Keynesian remedy was tried out for nearly two decades after the Second World War; and the unemployment rate in the advanced capitalist countries was indeed kept at levels that were extremely low by the historical standards of capitalism. But with the ascendancy of international finance capital, and the consequent transformation in the nature of the nation-State, whose interventions now are meant exclusively for promoting the interests of finance capital, Keynesian “demand management” recedes to the background; and we are back to a regime of booms and busts associated with the formation and collapse of “bubbles”. The current crisis is not caused by any aberration on the part of financial institutions; it is immanent to a regime of finance capital.