IBG: Foundation of American Finance Capitalism?
Thomas Friedman delivers today with a column that makes me proud he’s a fellow Marshall Scholar. My favorite paragraphs:
I have no sympathy for Madoff. But the fact is, his alleged Ponzi scheme was only slightly more outrageous than the “legal” scheme that Wall Street was running, fueled by cheap credit, low standards and high greed. What do you call giving a worker who makes only $14,000 a year a nothing-down and nothing-to-pay-for-two-years mortgage to buy a $750,000 home, and then bundling that mortgage with 100 others into bonds — which Moody’s or Standard & Poors rate AAA — and then selling them to banks and pension funds the world over? That is what our financial industry was doing. If that isn’t a pyramid scheme, what is?
[T]his legal Ponzi scheme was built on the mortgage brokers, bond bundlers, rating agencies, bond sellers and homeowners all working on the I.B.G. principle: “I’ll be gone” when the payments come due or the mortgage has to be renegotiated. . . . The Madoff affair is the cherry on top of a national breakdown in financial propriety, regulations and common sense.
Thank you, Mr. Friedman. Finally, respectable opinion is coming around to a view that the “man on the street” has intuited for some time: the recklessness of contemporary finance capitalism is systemic, not merely the product of a few bad apples. A passion for deregulation and budget cuts left an administration unable to detect even the grossest frauds. In that culture, virtually anything went. And as the Bush years come to a close, I expect many inspector generals across the administrative state will be detecting ever more wrongdoing.
Friedman reported on Chinese dismay at the breakdown in the American system, and the growing international sense that US assets are being hollowed out by a craven superclass. James Fallows’s interview with Gao Xiqing, “the man who oversees $200 billion of China’s $2 trillion in dollar holdings,” gives another perspective on the Chinese view of America’s descent toward kleptocracy:
If you look at every one of these [derivative] products, they make sense. But in aggregate, they are bullshit. They are crap. They serve to cheat people. I was predicting this many years ago. In 1999 or 2000, I gave a talk to the State Council [China’s main ruling body], with Premier Zhu Rongji. They wanted me to explain about capital markets and how they worked. These were all ministers and mostly not from a financial background. So I wondered, How do I explain derivatives?, and I used the model of mirrors.
First of all, you have this book to sell. [He picks up a leather-bound book.] This is worth something, because of all the labor and so on you put in it. But then someone says, “I don’t have to sell the book itself! I have a mirror, and I can sell the mirror image of the book!” Okay. That’s a stock certificate. And then someone else says, “I have another mirror—I can sell a mirror image of that mirror.” Derivatives. That’s fine too, for a while. Then you have 10,000 mirrors, and the image is almost perfect. People start to believe that these mirrors are almost the real thing. But at some point, the image is interrupted. And all the rest will go.
When I told the State Council about the mirrors, they all started laughing. “How can you sell a mirror image! Won’t there be distortion?” But this is what happened with the American economy, and it will be a long and painful process to come down. I think we should do an overhaul and say, “Let’s get rid of 90 percent of the derivatives.”
Fans of Fischer Black-inspired financial wizardry may blanch. But we need a fundamental reconsideration of the modern “science” of finance, as this essay shows, systematically deconstructing the myths that got us where we are today:
Neoclassical economics . . . is based on the following assumptions:
i. Most of the time markets are in or close to stable equilibrium, ii. Participants in markets act rationally to maximize fixed and known preferences described by definite and time independent utility functions., iii. Participants in markets have perfect knowledge of the information driving the markets as well as all other participants., iv. Prices are set by a deterministic process of joint maximization of the preferences of all involved in a trade, v. Fluctuations in prices are small, random and uncorrelated, vi. There is perfect liquidity so all prices are well defined, and all markets clear, vii. There is no important difference between markets comprising a few individuals and those comprising millions, so simple models suffice to elucidate the principles that govern markets.
The neoclassical paradigm based on these ideas has had some undisputed successes. At the same time, it appears to have led to the adoption of practices and recommendations, which are at least partly at the root of the present crisis. These included the ideas that,
i. Regulation is limited or unnecessary because markets find and stay close to stable equilibrium where they operate most efficiently, leading to maximally stable economic growth, whereas regulation only leads to slower growth. But we face a potentially precipitous decline in economic growth and prosperity in the wake of some deregulation.
ii. Everything has a value or price, at all times, that can be uniquely determined by some definite objective process. This includes contracts that refer to prices of fluctuating variables at future times. There is experience with futures contracts, which have prices which are set daily by their being actively traded. But we are now seeing these values evaporate.
iii. This trading experience may be generalized to a claim that complex financial instruments which oblige actions to be taken at future times based on conditions not known till then, still have definite values and prices even if they are never or rarely traded. But part of the crisis is due to the fact that the balance sheets of banks and companies holding these contracts cannot be computed because they include instruments whose prices have been revealed as simply hypothetical and are now proving to be indeterminate .
iv. Stability can be increased by inventing and trading abstract complex financial instruments rather than principal contracts like stocks and mortgages. Examples are derivatives. . . . The theory behind the possibility of combining fluctuating variables into variables that fluctuate less is critically dependent on the above assumptions, especially that the fluctuations are small, random and uncorrelated. But these assumptions have been shown to be false.
v. It has been argued that these innovative instruments should not be regulated even as much as stock trading because they function as insurance to increase stability. This was based on another false assumption that any mathematical function of the values of stocks at different times has a fixed and determinate value at any time.
vi. Because price determination is a definite process of maximization of known preferences in an environment of perfect knowledge, and because all values are definite, it can be in some instances automated and carried out by computers programmed to trade under specified conditions. But some markets thus operated have failed to function or clear trades.
I think the Edgesters behind the essay correctly diagnose the problems here, but may be making the same old mistakes they criticize when they try to address the crisis by reifying the economy as a physical system. If this crisis teaches us anything, it is that distributional questions are fundamentally moral. Our system has failed to recognize the inevitably value-laden nature of economic policy. As Linda Bilmes and Joseph Stiglitz lament, recent American economic policy has utterly failed to take this moral dimension of economic life into account:
The worst legacy of the past eight years is that despite colossal government spending, most Americans are worse off than they were in 2001. This is because money was squandered in Iraq and given as a tax windfall to America’s richest individuals and corporations, rather than spent on such projects as education, infrastructure, and energy independence, which would have made all of us better off in the long term.
President Bush did manage, by way of deficit spending, to grow the economy by 20 percent during his tenure. But who benefited from that growth? Between 2002 and 2006, the wealthiest 10 percent of households
saw more than 95 percent of the gains in income. And even within those rarefied strata, the gains tended to
be concentrated at the very top. According to one study, the nation’s 15,000 richest families doubled their annual income, from $15 million to $30 million. . . . .
Even as the wealthiest families have increased their holdings, the families at the center of the income spectrum saw their incomes shrink by 1 percent. In 2000, the average weekly earnings of production and nonsupervisory workers (70 percent of the workforce) amounted to $527 (in current dollars). Six years later, their
wages had risen a mere $11, and those same workers have meanwhile seen their net worth (assets minus liabilities) wither as a result of falling home values, higher personal debt, and shrinking savings—factors now being exacerbated by the collapsing stock markets.
And let’s not forget skyrocketing health insurance premiums. With benefit of hindsight, these windfalls for the wealthiest appear more and more pointless. Friedman and Gao are helping us see exactly the kind of conduct that was “incentivized” by tax cuts for the ultra-rich: feverish shuffling of representations of assets that ultimately metastasized the risk it was putatively managing.