Winning Progressive

(By NCrissie B)

I’ve been considering Yves Smith’s 2010 book ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism. In my first post, I looked at the economic theory that enabled the Great Recession. In the next post I examined how blind faith in that theory led to deregulation, looting, and the shadow banking system collapse. Today I conclude with Smith’s proposed remedies and our ideas for talking with median voters like our archetypal Fred.

Yves Smith is the founder of Naked Capitalism and has over 25 years experience in finance. A graduate of Harvard College and Harvard Business School, she has worked in corporate finance for Goldman Sachs, was the head of mergers and acquisitions for Sumitomo Bank, and currently heads Aurora Advisors in New York City. She has written for The New York Times, The Christian Science Monitor, and several other print and online publications.

The Story of Shady Eddie

Shady Eddie’s business card says he’s an electrician, and he is, sort of. Most electricians’ make a tough living, but Eddie and his bosses are raking in the dough. What’s their secret?

For starters, he uses complex, ‘innovative’ wiring schemes that use fewer and cheaper materials. Eddie’s bosses don’t understand his wiring schemes, but they’re making money so they don’t look too hard. City code enforcers don’t understand Eddie’s work either, but his company’s fees pay their salaries so they sign off on the permits. He also gets do to the rewiring when customer have problems, because no one else knows how to fix his work.

But even cutting corners on materials and getting the rewiring jobs aren’t Eddie’s real business secret. He knows that, sooner or later, at least some of the buildings he’s wired will have electrical fires. So he buys fire insurance. He makes a nice profit on the initial installations, gets paid again on the rewiring jobs, and gets yet another payday when the insurance check comes in.

Of course, Shady Eddie is only an electrician, so once the city catches on to him he’ll be charged with insurance fraud, at the very least. If only he’d become an investment banker instead….

Why They’re Not In Jail

Yves Smith explains that credit default swaps – the highly-leveraged bets that exploded the global economy in 2008 – are basically insurance policies against the failure of an underlying derivative. Many traders who set up those credit default swaps on mortgage-based derivatives knew the housing bubble would burst soon. In fact, many were structured so the trader stood to profit most when homeowners defaulted and the credit default swaps paid off. Like Eddie’s ‘creative’ wiring schemes, the mortgages were set up to fail, providing refinancing fees for mortgage brokers and bonuses for traders packaging those mortgages into derivatives. And as with Eddie’s scam, the traders convinced companies like AIG to guarantee credit default swaps if the mortgages failed.

But unlike Eddie, those credit default swaps were not regulated as insurance policies, so the traders weren’t committing insurance fraud … at least not under the law.

Shining a Light on Shadow Banking

Changing the law to regulate credit default swaps as insurance policies – not reinstating Glass-Steagall or breaking up ‘too big to fail’ banks – is Smith’s most compelling reform proposal. She concedes that credit default swaps are now so central to the ‘market-based credit’ model that the swaps cannot be shut down. But they can and must be regulated, including rules that require those who buy or sell swaps to have an insurable interest in the derivative on which the swap is based.

Smith acknowledges that regulating credit default swaps as insurance policies would increase the cost of the swaps, thus increasing the cost of the derivative bonds being insured, thus requiring the bonds to pay and the lenders to charge higher interest rates. In plain language, regulating the swaps as insurance would make credit more expensive.

And that, Smith argues, would improve the stability of the global economy. Cheap credit allows too many investors to leverage too much speculation – and creates too many profits for too many bankers – based on too little real productivity. “Finance should be the handmaiden of business,” she writes, “and not its master.”

While Smith does suggest reinstating Glass-Steagall, her reasons are not the reasons you’ll hear in the progressive media. Small commercial banks can be as profitable as larger competitors, because the services they offer do not benefit much by economies of scale. But investment banks benefit greatly by economies of scale. To remain competitive in an international market, investment banks must be ‘too big to fail’ and backed by implicit government guarantees.

A new Glass-Steagall, Smith argues, would both encourage small commercial banks to thrive again and also allow the federal government to treat huge investment banks as public utilities, with what she calls “strict and intrusive” regulations on their risk-taking, accounting, and compensation practices. If investment banks require government support during market crises – and they will – then government must be able to limit the risks being underwritten by We the People.

Alas, Smith acknowledges that enacting these reforms will require both business and political leaders to abandon the myth of Marketopia. She does not believe that will happen until the ‘free market’ dogma has failed so completely that its manifest flaws can no longer be excused away. And on that point I disagree.

President Obama and several other Democrats like Elizabeth Warren are using their 2012 election campaigns to make a case for shared responsibility and regulated markets that allow capitalism to flourish. If we activists do our part to help – including telling archetypal Fred the story of Shady Eddie – polls show that President Obama, Ms. Warren, and other Democrats can win on that case and change our economic dialogue.

Realworldia is not as tidy as the precise formulas of Marketopia. But we live in Realworldia, and our political and economic systems must admit that.

(Crossposted from Blogistan Polytechnic Institute (BPICampus.com))

 (By NCrissie B)

In this series, I’ve been considering Yves Smith’s 2010 book ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism. Previously I looked at the economic theory that enabled the Great Recession. Today I examine how blind faith in that theory led to deregulation, looting, and the shadow banking system collapse. In the next post, I’ll conclude with Smith’s proposed remedies and our ideas for talking with median voters like our archetypal Fred.

Yves Smith is the founder of Naked Capitalism and has over 25 years experience in finance. A graduate of Harvard College and Harvard Business School, she has worked in corporate finance for Goldman Sachs, was the head of mergers and acquisitions for Sumitomo Bank, and currently heads Aurora Advisors in New York City. She has written for The New York Times, The Christian Science Monitor, and several other print and online publications.

Selling a Myth

The Wall Street Journal‘s Charles Murray thinks capitalism has an image problem:

Mitt Romney’s résumé at Bain should be a slam dunk. He has been a successful capitalist, and capitalism is the best thing that has ever happened to the material condition of the human race. From the dawn of history until the 18th century, every society in the world was impoverished, with only the thinnest film of wealth on top. Then came capitalism and the Industrial Revolution. Everywhere that capitalism subsequently took hold, national wealth began to increase and poverty began to fall. Everywhere that capitalism didn’t take hold, people remained impoverished. Everywhere that capitalism has been rejected since then, poverty has increased.

“Capitalism” can mean many things, and Murray’s claims about its success do have merit, depending on which definitions you choose. He goes on to argue, as conservatives and libertarians often do, that the Great Recession was a cultural rather than a systemic failure. The problem lay not in capitalism, but rather in the erosion of cultural norms that let greed run amok.

Yet what if pursuing the sort of capitalism Murray proposes – one where government acts only to “enforce laws against the use of force, fraud and criminal collusion, and use tort law to hold people liable for harm they cause others” – was in fact the primary reason those cultural norms eroded?

Deregulation and Drift

Yves Smith makes that case in ECONned. Like many progressives, I blamed the Great Recession mostly on the repeal of the Glass-Steagall Act that, since 1933, had kept investment and commercial banking separate. In fact the repeal of Glass-Steagall was at most a tiny part of the story. Smith argues that law was largely a dead letter by the time of its repeal due to variances granted by regulators, many of them arguably worthwhile. As we’ll discuss tomorrow, Smith acknowledges the economies of scale that allow large banks to offer a range of financial services at lower cost than would dozens of smaller firms offering only one or two services each.

And as the Washington Post‘s Steven Pearlstein notes, the financial firms that collapsed in 2008 were not and had never been commercial banks. Bear Stearns and Lehman Brothers were investment banks. AIG was an insurance company. None would have been regulated under Glass-Steagall, which covered only commercial banks, and commercial banks came through the Great Recession largely intact. So what went wrong?

The problem, Smith argues, was blind faith in the neoclassical dogma of self-correcting markets. That led to many other examples of deregulation, such as changes in accounting rules that let banks and traders overstate their assets and underestimate their risks. It also led to what Paul Pierson and Jacob Hacker call “policy drift,” the failure to create new regulations as complex derivatives emerged and came dominate the credit market. Congress chose not to regulate those derivatives, and by 2005 the total of loans financed by complex derivatives – traded by and through investment banks – exceeded the regulated loans and other instruments offered by commercial banks.

Looting in the Shadows

The rise of this “shadow banking” – leveraged and re-leveraged through borrowing on still more complex derivatives – allowed traders to build enormous levels of risk. In the mythical Marketopia, there was no reason for government to supervise that risk. Investment bank executives would ensure their traders did not put the bank in peril of collapse, and the pension funds and municipalities that bought derivative bonds would apply due diligence to ensure the prices and returns offset their risks.

Meanwhile, back in Realworldia, bank executives lacked the expertise to understand the complex derivatives their traders were creating and selling. Senior executives had no way to know their Value at Risk (VaR) models had badly underestimated how a shock could spread into seemingly unrelated markets, and how quickly the spreading failure could consume their firms’ assets. Worse, accounting rules allowed firms to post the projected future profits on a derivatives bond issue in the quarter that deal closed, and compensation contracts paid executives and traders on those projected future profits – with few if any penalties for underperforming past deals – again on the assumption that the market would expose any shady dealing.

The predictable result was that traders began looting, hiding risks both from the customers who bought derivatives bonds and from their own bosses. So long as the big bonus checks kept rolling in, senior executives had few incentives to have their risk management departments scrutinize the books. Even if they had, their risk management accountants – like the analysts at the ratings agencies that graded the bonds – used the same VaR models and lacked the expertise to challenge the equations or their results. As for the pension and municipal fund managers buying the bonds, they were sheep to be fleeced.

Smith presents compelling evidence that traders creating the shady bonds did know the risks. By 2007, the volume of credit default swaps matched that of new bond issues, and the swaps were hedging against those very same bond issues. The structure of these hedge bets meant traders would only profit if the mortgage-based bonds they sold were indeed junk, letting them claim bonuses on the profits before their firms – and the bondholders and insurers like AIG – were stuck with the losses.

All of that was backstopped by the investment banks’ experience with the “Greenspan Put” and the ongoing, implicit promise by the U.S. and other governments to bail out big financial firms when the house of cards began to collapse. Even had governments wanted to let the firms fail, the “shadow banking” system had become so dominant that its failure threatened the entire global economy. As Smith writes, “It is hard to discipline someone who is holding a knife to your throat.”

Conservatives would point to that last paragraph as proof that the Great Recession was all the government’s fault. If government hadn’t implicitly promised to bail out failing banks, the argument goes, none of the rest would have happened. Executives would have magically acquired the expertise to understand the deals their traders were making, despite the bonuses the executives earned from those deals. Ratings analysts and pension and municipal fund managers would have been more skeptical of the VaR models. The ‘free hand of the market’ would have sorted everything out.

But as we saw previously, the conservative argument presumes Marketopia … and this story happened in Realworldia.

(Crossposted from Blogistan Polytechnic Institute (BPICampus.com))

(By NCrissie B)

This week I consider Yves Smith’s 2010 book ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism. Today I look at the economic theory that enabled the Great Recession. In the next post, I’ll examine how blind faith in that theory led to deregulation, looting, and the shadow banking system collapse. Then I’ll conclude with Smith’s proposed remedies and our ideas for talking with median voters like our archetypal Fred.

Yves Smith is the founder of Naked Capitalism and has over 25 years experience in finance. A graduate of Harvard College and Harvard Business School, she has worked in corporate finance for Goldman Sachs, was the head of mergers and acquisitions for Sumitomo Bank, and currently heads Aurora Advisors in New York City. She has written for The New York Times, The Christian Science Monitor, and several other print and online publications.

Beyond the Search for Villains

Economists have a mystique among social scientists because they know mathematics. They are quite good at explaining what has happened after it has happened, but rarely before. I don’t think of myself as an economist at all. — Daniel Kahneman, Nobel Laureate

There is no shortage of theories to explain the Great Recession. Villains abound: greedy bankers, bought-off ratings agencies, clueless pension fund managers, shady mortgage brokers, and the working poor living beyond their means. Some blame policies and political actors: regulation, deregulation, taxes, tax cuts, deficit spending, spending cuts, Congress, the SEC, the EPA, Fannie Mae, Freddie Mac, lobbyists, and public employee unions.

Each of these theories has elements that seem plausible, and parts of each may be true, yet Yves Smith argues that none addresses the deeper issues: a flawed theory – neoclassical economics – and the almost unchallenged acceptance of that theory by business and political leaders.

Dr. Kahneman’s statement nicely encapsulates the opening three chapters of Smith’s book. Applying rigorous, scientific-seeming mathematical equations and logical proofs, neoclassical economics claims to offer a comprehensive theory of how markets work. By implication, it also claims to offer a policy roadmap for government. Create the conditions described in the theory – the neoclassical argument goes – and markets will work as the theory proves: efficiently and to the benefit of everyone. Yes, some will benefit more than others, but even the poorest and most vulnerable will still be better off than they would have been under any other system.

Storytelling with Mathematics

Given the conditions that serve as premises for neoclassical theory, that ideal outcome would happen. The equations prove it. Yet however much neoclassical economics looks like a science, Smith writes, as applied to Realworldia the theory is little more than “storytelling with mathematics.”

The break point between science and storytelling, she argues, exists in those “conditions that serve as premises.” Specifically, neoclassical theory presumes:

• Rational economic actors – This means that every actor seeks to maximize his/her utility (most gains, least costs) as predicted by game theory equations that include calculable benefits, risks, and probabilities.
• Individual, equal actors – All economic actors act as individuals, each with equal market influence.
• Efficient markets – This refers to information about transactions, and proposes that every actor quickly has access to (or that prices already reflect) all relevant information about any transaction.
• Zero transaction costs – This means a frictionless market where it costs nothing to conduct a transaction, such that any buyer can shift from seller to seller, and any seller from buyer to buyer, with no loss in utility.
• Liquid, continuous, uniform markets – This means that any good or service that anyone might want can be bought or sold, that the market will remain open indefinitely such that a buyer can resell any unused good or service, that any specific good or service is indistinguishable from others of that type, and that all buyers want and will accept an equal quantity of any given good and service.

If all of those conditions (and a few others I didn’t list) exist, the equations of neoclassical economics prove that every buyer will find one or more seller, every seller will find one or more buyers, and the result will be a Pareto optimal equilibrium where no actor can improve his/her position without harming one or more other actors in the market, who would and could act within the market to block that attempt.

What happens if one or more of those conditions does not exist? In ‘free market’ ideology, the answer is that all of those conditions would exist, if only government would get out of the way. As is said so often, “It’s Economics 101!” Welcome to Marketopia.

Economics 102: Meet Lipsey-Lancaster

Meanwhile, back in Realworldia, we know that not all of those conditions do exist. Indeed not all of them can possibly coexist. Humans are not entirely rational – in game theory terms – nor do we act only individually or have equal market influence. Even if humans could and did act with perfect game theory rationality, we would still need all of the relevant information about a given transaction. Goods and services are rarely if ever identical to others of the same type, and sellers often know more than buyers about the advantages and disadvantages of the goods and services they offer. As rational actors, sellers could and would (and can and do!) try to conceal some of that information, and profit on the resulting information asymmetry.

What’s more, any attempt to ensure every actor has all relevant information about each transaction will inevitably create transaction costs (to research and ensure full disclosure of that information). It is not possible – not even as a theoretical exercise – for markets to be both information-efficient and transaction cost-free.

And here’s the kicker: back in 1956, economists Richard Lipsey and Kelvin Lancaster showed – with the same rigorous mathematical equations and logical proofs – that if you can’t meet every required condition for a Pareto-efficient outcome … you cannot assume the next best strategy is to ‘perfect’ each of the remaining conditions. Indeed, the next best possible outcome almost always requires moving one or more of the other conditions away from the theoretical ‘ideal’ states.

In plain language: if not every human will be a rational actor, or if not every human will act as an individual and have equal market influence, or if not everyone will have all relevant information about every transaction, or if their are transaction costs, or if not every market is liquid, uniform, and continuous … trying to push the other conditions to their ‘ideal’ states will almost always make the system worse.

There’s good news. Economists know the weaknesses of neoclassical theory, and that’s why only 3% of economists are “strong supporters” of ‘free market’ solutions. Alas, too many other, louder economic voices – pundits and business and political leaders – keep yelling “It’s Economics 101!” … and tomorrow we’ll see how their blind faith in the flawed neoclassical theory guaranteed the Great Recession.

(Crossposted from Blogistan Polytechnic Institute (BPICampus.com))