TWN Info Service on Finance and Development (Aug11/02)
19 August 2011
Third World Network  

Debacle, an incurable result of fraud, aided by technology
Published in SUNS #7210 dated 12 August 2011

Geneva, 11 Aug (Kanaga Raja*) -- The failure of the world economy, and particularly the financialised economies of Europe and North America, to recover from the financial debacle is a product of the character of the debacle itself: absolute distrust leading to absolute liquidity preference is the "incurable" consequence of financial fraud, aided by a world of technology that created financial instruments of uncontrolled complexity.
 
This view was voiced by the US academic and economist James K. Galbraith in a keynote lecture at the fifth annual Dijon conference on post-Keynesian economics at Roskilde University near Copenhagen, Denmark on 13 May.
 
Galbraith's views, analysis and stinging critique, not only of the financial crash but the inability or failure of "mainstream" economists and regulators to face up to the criminal fraud at the heart of the crisis, has become more widely known over the week or so, after a transcript* of his address (from a sound recording) was posted on the blog "my FDL" and in turn hyperlinked and favourably noted by Yves Smith last week on the "Naked Capitalism" blog.
 
"The corruption and collapse of the rule of law, in the financial sphere, is basically irreparable. In other words, we are at the end of the illusion of a market place in the financial sphere," warned Prof. James K. Galbraith, whose father was the economist John Kenneth Galbraith, an exponent of Keynesian and institutional economics who had served in several administrations - from Franklin Roosevelt to Lyndon B. Johnson - and was twice awarded the Presidential Medal of Freedom.
 
Prof. James K. Galbraith teaches at the Texas University's LBJ School of Government at Austin.
 
In his lecture, Galbraith delved into three major aspects of the British economist John Maynard Keynes' thinking, which he said had bearing and application to the financial crisis, and also identified these aspects with Wynne Godley, Hyman Minsky and Galbraith pere.
 
According to Prof. Galbraith, Godley had worked in the Keynes, Kuznets, Kalecki, Kaldor tradition of macroeconomic models attentive to national income accounting identities and to consistency between stocks and flows. The virtue of this approach, he said, is clarity and a comparative lack of overreaching ambition. Models of this type "say nothing false which may not seem like much, but it's a huge advantage over the starting position in (today's) mainstream economics which consists of nothing which is true."
 
Galbraith said that the federal surpluses in the United States' budget in the late 1990s implied unsustainable private debts was clear to those working in this tradition at the time, just as, the fact that household debt burdens were again unsustainable was clear in the 2000s.
 
Policy in a country like the United States, he noted, is very strongly influenced by the macroeconomic forecasting of institutions like the Congressional Budget Office "which impose no such consistency constraints on their models and do not check to see whether forecasts in one area imply reasonable and plausible outcomes in another."
 
For this reason, much of that work is essentially nonsense, added Galbraith.
 
Minsky, he noted, developed an economics of financial instability, the intrinsic consequence of overconfidence mixed with ambition and greed, and that his approach, which was very different from Godley's, is conceptual rather than statistical. "A key virtue is that it puts finance at the center of economic analysis, analytically inseparable from what is sometimes called real economic activity, for the simple reason that capitalistic economies are run by banks."
 
"To grasp what Minsky is about, it seems to me, is to go immediately beyond the coarse notion of the ‘Minsky moment', a concept which implies falsely that there are also non-Minsky moments," said Galbraith, adding that it is to recognize that the financial system is both necessary and dangerous, and that strict financial regulation is both indispensable and imperfect.
 
"Just as with any machinery from an automobile to a nuclear reactor, a long record of stable performance does not prove that the controls and the backup systems are perfect anymore than it can show that they are unnecessary. Argument otherwise, whether made by the head of the central bank or an applicant for a license extension before the Nuclear Regulatory Commission is the mark of a crank."
 
The Galbraithian line is allied to and descended from Keynes in the same sense that his father's work was: "accepting the central role of aggregate effective demand, the national income accounts, the credit circuit view of economic life and the financial instability hypothesis... But, it is also embedded in a legal institutionalist framework, rooted in pragmatism, framed by Thorstein Veblen and John Commons, forged in the political economy of the New Deal in the United States," said Galbraith.
 
This tradition emphasizes "the role played in financial crisis by the breakdown of law and the failure of governance and regulation - and the role played by technology as a tool in the hands of finance for the purpose of breaking down and evading the law."
 
He stressed that "Keynesian lines of analysis are most pertinent for an understanding of what we've been through and are still going through".
 
"When you engage the mainstream on the national income accounts, at least they know what the damn things are. And these days you can even get, though for who knows how much longer, a respectful mention of Minsky even from someone like Larry Summers, if not any sign that he has actually read him."
 
However, he noted, what cannot be gotten either at a meeting sponsored by the IMF or from participants at the Institute for New Economic Thinking is any serious discussion of contract law and fraud.
 
"No one will deny, in response to the question, the role that fraud played in the financial debacle. How could they? But they won't discuss it either. And it seems to me, this reflects a logic which bears pursuing," Galbraith told the audience at Roskilde University (Denmark).
 
"Why not? Why is this one of the great taboo topics of our modern economic history? Well, personal complicity, frankly, plays a role among present and former government officials, regulators, consultants and the academics who advised them and those who either played the markets or took fees from those who did... There is a web of negligence and complicity here. Of culpability, abetted by the way universities are funded and by what they teach."
 
Framing it in more abstract terms, Galbraith said that commodity is the foundation stone of conventional economics, and the theory of exchange requires the commodification of tradable artifacts. "Without that, there is no supply and demand. A world of contracts, each backed by a separate and distinct set of promises each only as good as the commitments made specifically and the ability of the laws and courts to enforce them, is a different sort of world.
 
"Just because you can call a set of such contracts by a name, ‘collateralized debt obligation' or ‘credit default swap', and just because you can create something - you may even be able to create something called an exchange to trade them on - does not make them into commodities with a meaningful market price."
 
According to Galbraith, complexity here is what is going to defeat the market with, in principle, infinite variability, and in practice, more distinct features than one can keep up with. "In great volume, contracts of these kinds are per se hyper-vulnerable to fraud."
 
He commended as a must read, the US Financial Crisis Inquiry Commission Report, the report of the US Senate Permanent Committee on Investigations, the many reports of the Congressional Oversight Panel, and the report of the Special Inspector General for the Troubled Asset Relief Fund - SIGTARP.
 
These reports, he said, brought out that "fraud was not a bug in the system, it was a feature. The word itself, along with abusive, egregious, reckless and even criminogenic suffuses these accounts of what went on," stressed Galbraith.
 
Galbraith said: "Godleyans teach that stocks cannot be separated from flows. Minskyans teach that finance cannot be separated from reality. And my father's tradition is that the legal and the technological cannot be separated. The financial world, as it exists, has nothing to do with the commodity world of real exchange economics with its delicate balance of interacting forces."
 
"It is the world of technology at play in the form of quasi-mass produced legal instruments of uncontrolled complexity. It is the world of, in other words, of evolutionary specialization in the never-ending dance of predator and prey. In nature, when predators achieve an overwhelming advantage, the prey suffer a population crash, from which the predators in turn suffer later on. In economics it's a financial crash, but process and dynamics are essentially similar," he added.
 
Noting that neither corporate fraud nor financial fraud are new, Galbraith said that what was new here was the scale and complexity of debt obligations, backed by mortgages. Long-term mortgages have existed in the US since the New Deal but they were rendered manageable for decades by their simple uniform structure, their substantial margin of safety and the fact that the secondary markets were public and imposed standards on what could be issued and on what could be passed on to the agencies created for refunding those markets. And what this meant was that supervision was possible.
 
"In the computer age, on the other hand, we entered the world of private labelled securitisation, of negative amortization payment optional, Adjustable Rate Mortgage with a piggyback to cover the down payment. Oh, and documentation optional," he said.
 
He went on to cite some well-known jargon in the financial industry for these loans and related financial products, namely, liars' loans, NINJA loans (the borrowers had no income, no job or assets), neutron loans (loans that would explode destroying the people but leaving the buildings intact), and toxic waste (the residue of the securitisation process).
 
"I suggest that this tells you that those who sold these products knew or suspected that their line of work was not one hundred percent honest. Think of the restaurant where the wait staff refers to the food as scum, sludge and sewage," he said.
 
According to Galbraith, rendering such complex and numberless debt instruments comparable would require a statistical approach based on indicators.
 
He noted: "The world of credit scores, ratings and algorithms, a world of derivative and super derivative instruments of sliced and diced residential mortgage backed securities, collateralized debt obligations, synthetic CDOs [collateralized debt obligations], synthetic CDOs squared, credit default swaps - all designed to secure that triple-A rating and to place the instruments which had been counterfeited to begin with - they looked like mortgages but were not really mortgages. Laundered, that is to say, transformed from the trash that they were into a triple-A security and fenced, which is to say, sold to the legitimate investment market by an intermediary called a commercial or an investment bank."
 
Citing the US institutionalist Clarence Ayres as stressing the role of technology and the irreversible contribution of new tools to the production process, Galbraith said that in the world of finance, it's the algorithm that is this tool. "A radically cheap substitute for underwriting, a device for converting the financial gain into a computerized casino in the strict sense where one can never be sure by how much the house is bending the rules."
 
Noting that Keynes understood these issues very well so far as they went in his time as an active player in the speculative markets, Galbraith however said that in Keynesian terms, "what we have seen since the financial crash should be no surprise at all. That is to say, the failure of the world economy and particularly of the financialised economies of Europe and North America, to recover from this debacle is a product of the character of the debacle itself. Absolute distrust, leading to absolute liquidity preference is the incurable consequence, it seems to me, of financial fraud."
 
This is the diagnosis of an irreversible disease. The corruption and collapse of the rule of law in the financial sphere, is basically irreparable: it's not just that restoring trust takes a long time but that under the new technological order in this field, it cannot be done.
 
"The technologies are designed to sow and foster distrust and that is the consequence of using them. The recent experience proves this, it seems to me. And therefore there can be no return to the way things were before. In other words, we are at the end of the illusion of a market place in the financial sphere."
 
On the crisis in Europe, Galbraith said that Greece will not be able to implement the programmes demanded of it without crashing its GDP, and driving up its debt to GDP ratio on that account. "There is no national policy solution and no financial market solution."
 
There will be a restructuring or a default, and there must be an economic and not merely a financial rescue. And beyond that there obviously must be not only a new European architecture, but a new financial architecture that is not built around the banks as they exist today and the credit markets as they came to exist in the period before the crisis. Either that or the depression in Europe will simply go on and on, until eventually the European Union falls apart.
 
In concluding his lecture, Galbraith stressed the need for building a new line of resistance.
 
Amongst others, he called for an understanding of the money accounting relationships that pertain within societies and between them, in order not to be panicked by mere financial ratios into self-destructive social policies or be condemned to lives of economic stagnation and human waste.
 
He also stressed the need for and effective analysis of the ongoing debt deflation, the banking debacle and what he said are the inadequate fiscal and illusory monetary policy responses so far, and that attention also needs to be drawn to the fact that in America and in Europe, the crisis is primarily that of banks, not of governments.
 
Galbraith also called for a full analysis of the criminal activity that destroyed the banking sector, including its technological foundation, so as to quell the illusion that these markets can effectively be restored to anything like their form of 4 or 5 years ago.
 
There is also the need for the reconstruction of the instruments of public power, namely, the power to spend, the power to tax, the money power and the power to regulate, in order to effectively pursue these goals with democratic checks and balances to prevent the capture of new state institutions by predatory forces.
 
(* The full transcript of the lecture by Prof. James K. Galbraith at Roskilde University has been posted at my. firedoglake. com/selise/2011/08/01/james-k-galbraith-the-final-death-and-next- life-of-maynard-keynes/. The link for the audio file is at http://utip.gov.utexas.edu/Video/Roskilde%20PK%20Keynote%20JG.WAV) +