Financial Crisis Inquiry Commission

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The FCIC and Political Economy

In the old days, before orthodox economists decided to try to look scientific, economics was more commonly called “political economy” or some such thing. Evidently the discipline’s founders had no problem with advertising the obvious connection between the study of matters economic and matters politic. The two seem a natural pairing. Especially when it comes to giving advice on policy. Thus the great political debates about the Corn Laws in the UK provided the context within which people like Ricardo began the development of what we now call simply “economics”.

But it really is political economy. It doesn’t seem that scientific to me at all. Not when it disappears into the methodological individualist rationalist rabbit hole. In order to create the pretense of being scientific economists had to decide what they meant by science. On reflection it appears they had a very narrow view. Lots of math. Lots and lots of math. Did I say lots of math? If not I meant to. Economics is now a branch of applied mathematics with an emphasis on constrained optimization. On the periphery economists talk about other stuff, but at the core, oddities such as dynamic stochastic general equilibrium – phew! – is what counts. Of course in order to strip away non-mathematical material, and to focus on doing the math, economists had to throw overboard all sorts of interesting topics, many of which would strike you and me as being the very essence of an economy. Or at least interesting from a general social perspective.

This all came to a head during the 1930’s when ardent free market economists were being forced to defend capitalism from the then healthy challenge represented by both fascism and communism. Note that the idea was to defend capitalism, not to study economies. This would be like defending alchemy against the intrusions of chemistry rather than studying actual chemical things. So convinced were these free market types that they convinced themselves that no matter how twisted their logic or how absurd their assumptions they were truly scientific as long as the answer was “correct”. One might wonder what the correct answer was.

Well guess.

It was what they wanted it to be. Free markets, unencumbered by the evils of government intervention are always – always – a better coordinating device for an economy than any heavy handed centrally planned way of doing things. So they say.

Set aside the fact that every single one of our large corporations is a centrally planned economy. That’s different apparently. In the wonderland of free market economics it is cheating to mention real world phenomena.

And also set aside that the only way the free market emerges as the clear winner is to assume everyone knows everything. Yes that’s stupid, but it’s necessary to get the “correct” answer. It also raises the knotty problem that if everyone knows everything then, presumably, an omniscient central planner would arrive at the same coordination solution as the omniscient market does. Whoops. How do we tell the difference?

Ideology.

In other words we are discussing political economy.

I raise all this because of today’s news.

Rumbling along for some months has been something called the Financial Crisis Inquiry Commission. This august and worthy group was charged with determining the causes of the fiscal meltdown, and to advocate some measures that would help us avoid a repetition. The news is that the group is hopelessly divided along political lines.

This is no surprise. In contemporary America everything is divided along political lines. Even the air we breath is either left or right wing depending on whether it makes you cough. So to read that the Republican members of the commission plan to release their own findings is no shock at all.

Nor is it shocking to read their definition of the culprit.

It was the government.

Who would have guessed that?

Yes. The US government was entirely to blame for the collapse of the mortgage market, the real estate bubble, toxic asset accumulations, rotten risk models, unsafe leverage ratios, and all sorts of other sins. Had the silly government stayed well away none of this would have happened. And at the very heart of the problem? You guessed it. Fannie Mae and Freddie Mac. The twin evil towers of the government’s attempt to socialize real estate and force unsuspecting banks to make loans that they would never have made otherwise. The very worst example of government coercion of the poor innocent bankers is that neo-socialist Community Reinvestment Act designed to channel hard earned money into poverty stricken areas populated by irresponsible poor people who should never be allowed to borrow. All those CRA loans were the thing that brought the entire edifice crashing down. Why do we know those people were irresponsible? Because they’re poor, and they live in neighborhoods no self respecting banker would ever lend unless forced to.

None of this is true. None of it. But it is a rollicking yarn and conforms to right wing ideological interpretation of history.

It is political economy writ large.

That there are plenty of right wing mainstream economists who agree with it confirms what I wrote at the beginning. Getting at a neutral, “positive”, or truly scientific economics is devilishly difficult, if not impossible.

A goodly part of the problem stems from the orthodox view that there are no structures in an economy, and that the only subject worthy for study is the rational individual. Those of you in the UK will remember Margaret Thatcher’s insane comment that society doesn’t exist. She meant it didn’t exist in her ideological view. This is like saying that the only object for study in physics is the atom. Stuff like galaxies, planets, stars, molecules, and so on, are not worthy of consideration except in so far as they represent agglomerations of atoms. And forget anything smaller than atoms. That’s not possible in Thatcherite physics.

In economics, without structure as part of the subject, we can no longer study “group” effects or “group” activities. We cannot study the pull of fashion or the tug of class. Gender melts to nothing. Religion, and culture are rendered meaningless. And corporations are flattened into absurd caricatures. All this in order to ensure that any analysis produces the “correct” answer: free markets rule. Above all else the hideous specter of the government, that group of all groups, no matter how democratic, has to be expunged from our thoughts. That a market is a social group is conveniently overlooked. That “correct” answer must be arrived at.

This is old ground, and not usually exposed so visibly to the public gaze.

Yet today’s news is a stark reminder of the deep and permanent divide that has sundered economics. As political economy this is understandable. In such a setting the economic argument is openly about supporting an ideological position. Is it the capitalists? Or is it the workers? Who do we want to appear the driving force and thus the group to be nurtured or rewarded?

But in a positive economics, one based upon a dispassionate assessment of real world economies, this won’t do. Interpreting the fiscal meltdown would be a forensic exercise. We would be able to agree on the major points. Countrywide Bank and other unregulated rogue lenders would exist. So too would the long term effects of banking deregulation. That mortgages were bundled haphazardly and recklessly would also be in the report. That bankers relied on faulty economic theories about efficient markets would be there too. So would the rating agency habit of getting paid to raise their ratings to a satisfactory level. That a mortgage was called subprime precisely because it failed to live up to government standards for lending might also get a mention. Even if it mucks up the anti-government story line.

In the end this all makes me wonder whether we have any hope, any time soon, of executing a sensible economic policy. You know, one that actually helps us all, rather than one aimed at specific interest groups. So fractured is our polity, and so divided is the world of economics, that it is hard to see sense prevailing.

At the end of his great “Decline and Fall of the Roman Empire” Gibbon lists as one of the primary causes of that decline as being the intractable nature of the political divide that prevented Romans from acting in their collective welfare. So riven through with ill will and self referential focus had the various factions become that the failure of the state was more acceptable than any of the necessary policies needed to save it. The decline was inevitable.

I am ashamed that economics could be one of those self referential causes of our decline. Perhaps going back to our roots is one way to revive ourselves. Political economy sounds good enough to me. It sounds almost sensible.

Then again who can define “sensible” in our current context?

Addendum:

With all due respect to the Republican members of the FCIC, their analysis of the causes of the bubble falls apart at the very first step. How do they account for the crisis in Ireland, Spain, the UK and all the other non-American places where the exact same thing occurred? Is the evil US government so influential that it brought down Ireland as well? Did the Irish fall into the clutches of the CRA?

I think not.

Political economy indeed.

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Bank Crisis Aftermath: Greenspan Speaks

For those of us who have nothing better to do than get immersed in the banking crisis and its aftermath, this week has presented some riveting television. The Financial Crisis Inquiry Commission has been grilling some of the key players – dare I say villains? – of the implosion that led us into recession. Some of the conversation and questioning is revealing. Quite what this will all lead to is anybody’s guess, but in the meantime we are being treated to a typically American gala of recrimination, self-congratulation, and, in some cases, of reputation defending.

Yesterday’s star was Alan Grenspan, who amongst all the key players is probably most culpable, both for the actions he took and for the many that he refused to take. His testimony provides us with an acid test for the problems we face as we reconstruct banking to make it less damaging to our economic health.

With that in mind let’s pick apart some of his key points.

First off he reminds us that sub-prime lending has been around a lot longer than simply the past few years. It was a small, and well functioning segment of the mortgage market for the previous decade as well. Sub-prime loans were a way of extending home ownership to people who would never have been qualified for a regular loan. It was always higher risk business than regular mortgage lending, but because it was so small a piece of the whole market that risk was eminently manageable.

Where the wheels fell of was when home prices began their bubble driven rise.

Once home prices began that rise, many people who would have qualified for a normal mortgage found themselves being squeezed out of home ownership opportunities. In a nation obsessed with home ownership, and with a conservative political regime dedicated to private property as part of its ideological platform, lenders who began to deploy sub-prime techniques more broadly were encouraged rather than discouraged. Add in the inherent profit advantage sub-prime loans present the lender – which is only reasonable given their higher risk – and a we lay the groundwork for the disaster of 2006/2007.

At least this is Greenspan’s view.

He may be stretching things a little, but by and large this much is correct.

In and of itself however this would not have caused the crisis, we needed more ingredients.

The next that Greenspan identifies is the role played by the quasi-government agencies – the GSEs – Freddie Mac and Fannie Mae. These two bodies fell under intense political pressure to accommodate and encourage the boom in mortgage lending during the 2000’s. This pressure was a manifestation of the ideological approach of the Bush administartion, which is why it odd to see so many Republicans listing the GSEs as prime villains rather than supporting cast players. Greenspan himself falls into this same trap. Yes, the GSEs we part of the problem, but they were not responsible alone for the crisis, and they were coerced at first to jump into the quagmire that they then enjoyed so much later on.

Crucially, Greenspan cuts his data short when he throws blame the GSE’s way. He leaves off the two years immediately prior to the collapse. These were two years when the GSE’s role was much diminished compared with the extraordinary excesses of the private sector.

The next villain Greenspan list is the boom in securitization, and the foolery – my words not his – of the rating agencies.

It was securitization that opened the door for the final orgy of self-destruction the industry indulged in.

By dint of incompetent math, incredulous management, and outright greed on the front lines, banks willingly destroyed their balance sheets in a two or three year epic of stupidity.

The trick was that they rushed to lend ever larger amounts of sub-prime loans, making what had been a small segment of the business into the largest segment in no time at all. They then off loaded the loans by packaging and selling them to investors the world over. These investors thought they were buying safe assets – after all the rating agencies had confirmed that by giving the packages the highest possible rating. We all now know, of course, that the magic trick that converted the market’s riskiest loans into its safest was just that – a trick. The math wizards who invented the trick still haunt Wall Street, but their incompetence and venality was exposed on the grandest of scales.

What they believd was that by bundling together enough bad loans the package as a whole becomes less risky. The idea was that not all bad loans will go bad all at once. So if there are enough of them the cash flow from those that turn out to be OK will be more than sufficient to offset the losses on the inevitable, few, duffers. Whoops. The idea that the entire national housing market could implode at once never entered the febrile brains of these dolts. To be fair the data they used to convince themselves supported their case. Post war America had never experienced a national housing debacle. All the post war problems in housing had been local. So bundling a bunch of loans from all over the country looked like the safest of safe bets.

But American economic history doesn’t begin in 1945. Prior experience completely contradicts the evidence used by the bankers. But I imagine few of them wasted their time in history classes.

So Grenspan has laid the table for the crisis. The major ingredients are all there. His testimony is excellent, if sometimes self-selecting in its memory.

The final and crucial piece of the puzzle, and one few people mention, was the international economic conditions. Greenspan nails this well.

The story is a bit complicated as these things always are.

The point is that during the decade running up to the crisis the international economy was buffeted by a string of imbalances. The most important of these was the inability, or unwillingness, of some countries to expand their domestic consumption fast enough. That sounds arcane, but please focus on it. The upshot of this under-consumption was that the world economy was flooded with savings. Cash was everywhere. And it all needed a home. Investors were hungry for places to park their money and make good returns.

Let’s repaet that.

Some countries grew so fast that their domestic ability to consume was outstripped by their population’s new found wealth: China and India are classic examples. Both generated cash for investment, but their was simply not enough opportunity at home either to spend or to invest. So the money went into the global economy. Other countries, Germany and Japan, deliberately kept a lid on domestic consumption, which had the same effect: their populations ended up with extra savings that needed to be invested somewhere.

Either way, during the mid-2000’s the global economy was awash with cash and had too few investment opportunities.

Into which breach stepped the American banks and all those securitized loans. Those loans were the biggest single asset class available for investors around the world to buy. Since the loans were rated so highly, investors, mainly foreign banks and insurance companies, stepped up and bought billions upon billions of them.

This cash abundance was the vector through which what was a peculiarly American disease infected the entire world.

So when the American bubble burst it took the world with it.

That in a nutshell is what happened. As told by Alan Greenspan.

His examination of the regulatory response and the improvements we can make is also revealing.

In many ways he becomes old fashioned really quickly.

He advocates much higher capital levels for the banks. His argument being that had Lehman been better capitalized it would have weathered the storm. I doubt this. Lehman’s problems were more than this. It was running a shoddy book of assets, that turned out to be worth far less than its balance sheet suggested. Indeed at the loss rates it suffered even Greenspan’s suggested capital level of 15% would have been swamped.

Plus Lehman, like most of its kind, had developed an unhealthy reliance on short term funding. Greenspan recognizes this as well and advocates a much more stringent oversight of liquidity requirements.

My issue with this is that liquidity is a property of the system not an individual company. By this I mean that markets are liquid and that companies access liquidity only so far as the market remains liquid. Were such a market to freeze up and lose it liquid properties, then all the participants in that market suffer together. No one company loses its liquidity, they all do.

Where liquidity becomes an individual company issue is when it overlaps with solvency: do the other players in the market believe the valuation of the company’s assets it uses for collateral? If not it suffers more than the others. Which is what happened to both Bear Stearns and Lehman. No one believed their balance sheets.

So building a regulatory regime for the future needs to recognize that defending liquidity is the central banks role. Defending solvency is the individual company’s responsibility.

So while Greenspan is probably correct in arguing for much higher levels of capital and renewed emphasis on protecting liquidity, I am not convinced that we can arrive at easily constructed answers as to what those levels should be. There will always be an odd circumstance when even the highest level fails to save the bank.

Which brings me to a final comment on Greenspan’s testimony.

He litters his comments and his answers to questions with statements about the instability of banking and the waves of euphoria that sweep through it periodically. His analysis is oddly similar to that of Hyman Minsky, whose name I have mentioned here often. Minsky, you will recall, was the inventor of the Financial Instability Hypothesis, which is a theory about banking and its role in the economy based upon Keynesian economics, and in particular upon Keyne’s insight that the economy is inherently unstable due to the existence of uncertainty.

Throughout Greenspan’s testimony I get the feeling of someone grappling with the failure of long held ideas, theories, or beliefs. Sometimes he sounds almost naive in his statements, as if no one had ever though about things like this before. Or that no one could possibly have predicted the outcome the string of events he so capably summarized.

That’s my problem.

Plenty of people could. Anyone familiar with Keynes or Minsky for instance. Anyone who was not beholden to the market magic thinking that dominated Greenspan’s actions for is entire tenure at the Fed.

In other words: while Greenspan is to be congratulated for his revelations and his concise and accurate rendering of events, and, perhaps, for his latter day conversion away from market magic, he still bears responsibility. He could have listened. Instead he continud to drink from the same poisoned well as the bankers.

Instead of acting as a bulwark, he became a facilitator of their folly. He became a channel through which they spread the disease.

Unfortunately for him, that’s the way history will most likely remember him.

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The Crisis Commission: Day One

This is a week where news about the economy is scarce – the only notable data was the fact that the trade balance widened to $36.4 billion in November, which is both the worst since January last year and a fairly good sign that domestic activity is improving. So we learn nothing new even from this little piece of news.

So the focus stays on banking and, in particular, the proceedings of the Federal investigation of the financial crisis. Today is the first day of public hearings with notables like Lloyd Blankfein of Goldman Sachs and Jamie Dimon of JP Morganm Chase in the hot seat.

Already we’ve had a tense moment: Phil Angelides, the commission chairman, got us off to a fun start when he lashed into Blankfein with questions about Goldman’s nasty habit of selling investments such as mortgage backed securities, and then immediately turning around and selling those same securities short. You would only sell something short if you were convinced it was going to go down in value. So the obvious question is: did Goldman let investors know it thought the assets it was selling were worth a lot less than the amount it was charging for those assets?

Naturally Blankfein dithered in his answer, before admitting that, no Goldman did not advise investors of such problems.

His defense, if one can call it that, was that all the investors were ‘sophisticated’ and ‘analytical’ professionals who knew full well the risks they were taking. So Goldman had a right to presume the investors had done their due diligence on the assets before they went ahead and bought them.

In the sordid and ethically challenged world Goldman apparently inhabits such a response seems perfectly reasonable. To the less jaded and less ethically challenged eye, however, the fact that a purveyor of investments immediately hedges against those investments suggests that the disclosure was less than transparent, and may well border on fraud. That is fraud in an every day sense, not in the legal, carefully protected, and suitably obfuscated world of ‘Goldmanian’ finance.

Blankfien’s defense is intensely revealing. It opens up to our view a world where supposedly slick professionals who are ‘sophisticated’ and analytical’ shovel toxic crap into each others laps in order to make a quick buck. This is called high finance. Since everyone knows the rules, no one takes due diligence that seriously – instead they hedge against losses. They sanitize their lack of care by palming the loss of on someone else. The end game is to be stuck with less rubbish than anyone else, and to make sure all the toxic stuff you may own is covered by some sort of insurance.

It is a world where the old meaning of words is perverted. Due diligence used to be a careful method of risk mitigation. Now it is a perfunctory pre-sales function diminished by the after sales function of insurance. I suspect that much, if not the entire, volume of derivatives trading has become infected with such perversion. Indeed I would wager that most of the volume of derivatives exists because of the manic need of the big banks like Goldman to dump what they know full well to be toxic waste into an unsuspecting lap before it explodes and damages the bank’s bonus pool. No one does proper due diligence because everyone is buying insurance.

Angelides himself gave an analogy for the benefit of the press: Goldman’s method of investment sales is, he suggested, like selling a car knowing it had no brakes, and then buying insurance ‘in case’ it crashed.

To add to the blatant sleaze of Goldman’s business practices is the asymmetrical nature of Blankfein’s claim. Apparently his firm is correct to foist garbage on someone else because that someone else is presumed to be as sharp as Goldman in evaluating the risk of the transaction. But what happens when it is Goldman supposedly doing the due diligence,when it is the buyer, not the seller of a transaction?

Aaah. Then the rules change. How odd. When, for instance Goldman is suckered by AIG,. and has bought completely useless credit default swaps, AIG should be ‘honest’ and make Goldman whole. Poor little Goldman Sachs surely should not take a loss on transactions that big nasty AIG knew were rotten. This is, of course, the position that Tim Gethner took when he allowed the reimbursement of AIG’s counter-parties using taxpayer money. Those slick, smart and world class bankers had been given a sucker punch. They had failed totally in their due diligence. But instead of laughing at their stupidity, Geithner felt sorry for them and wrote out billions of dollars worth of checks. AIG not able to pay out all those CDS contracts simultaneously? Who knew? . Welfare checks for the poor bankers of Goldman anyone?

Double standard? Cheap and sleazy? Venal?

All of the above.

One thing is for sure: no one should ever respect the ethical standards of Goldman Sachs. There aren’t any. Which is a terrible shame, becasue when I did business with Goldman, years ago, their reputation was for being smart and slick – sharp in a good sense. Not simply sharp. The difference between the old Goldman and the current sleaze version is that it is no longer a private bank, and yet still pays as if it were. The risks are dumped onto shareholders, while the returns are kept inside for the employees. With that basic relationship severed the bank’s ethics went overboard and making a quick buck became the only thing that mattered.

Clearly customer relationships and reputation don’t count.

Too bad.

Break it up.

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Banking Reform: The Work Begins?

This week brings the beginning of the Financial Crisis Enquiry Commission’s public hearings. This body was set up early last year to investigate the origins and consequences of the bank implosion that brought our economy to its knees. The Commission’s chairman is Phil Angelides a former treasurer of California. He promises a thorough and illuminating investigation.

The public hearings that begin this week could not be happening at a more ironic moment: almost at the same time wall Street is entering its annual bonus bonanza and the amount of money being splashed around is rumored to be breathtakingly large. The average set aside at Goldman Sachs is said to be in excess of $560,000 per person.

While I realize that Wall Street has to pay its employees competitively, the sums being mentioned are ludicrous, egregious, and insulting all at once. They obviously don’t get it. Which is why I want to wish Angelides good luck. Someone has to rip Wall Street apart. I hope his commission is a beginning.

To argue, as Wall Streeters do, that they have reformed because they are now giving more of the bonus pool away as stock rather than cash simply aggravates the problem further. Nor is it good enough for them to say bonuses are now better tied to long term profits. Both these moves are improvements, but they are way too late and way too little. Bonuses should always tie performance with reward. That’s the very essence of a bonus. The anti-social, and darn nearly fatal to our economy, activities that Wall Street indulged in over the past decade were aided and abetted by bonus payments that made no true attempt to tie performance with reward. The measurements of performance were shallow and short term. The metrics were easily distorted in the employee’s favor, and too easily pumped up with scant regard for the longer term impact on shareholders or society at large.

All that activity may not have been illegal, but it defines unethical, and describes anti-social to perfection.

The banks robbed us blind.

Too much has been written about the games that the banks play in order to tilt the game in their favor, so I need not elaborate on those schemes here. All I need add is that all our major banks have lost, for all time, any shred of respectability. They deserve, indeed they worked hard to earn, the title of latter day robber barons.

That they are able to contemplate paying out seven or eight figure bonuses even as our economy tries to stutter back from the damage and carnage their actions wrought boggles the mind. They are not only clueless, but very obviously they inhabit a different universe. Not one or their executive leadership – if that is not an oxymoron – not a single one, deserves to be taken seriously as a balanced or healthy member of society.

To their claim that they are ‘forced’ to make these payouts in order to retain their key staff, my retort is simple: are these the key players who destroyed the economy? Are they the ones who bought CDS contracts from AIG without doing the simple due diligence that would have unearthed AIG’s inability to pay out? Are they the ones that constructed and sold Mortgage Backed Securities so riddled through with theoretical and practical error that we still don’t know what – if anything – they are worth? And are they the same people who funded the glut of commercial real estate that even now threatens to engulf the banks in a new wave of failure?

If so: let them leave. Send them packing. Denounce them. Let them flee the coop and go into private banks, hedge funds, and other corners where they will no longer represent such a clear and present danger to our society.

But for goodness sake don’t pay them obscene bonuses.

What are you thinking?

Good luck Mr. Angelides. Much as I would like to think you will be able to bring sanity back to banking, something tells me that the banks have already mobilized their lobbyists to blunt the thrust of your work.

I hope not. These people are a threat to us all. They must be stopped.