TWN Info Service on Finance and Development
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,
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
"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
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
"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
"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
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
"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
"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.
The link for the audio file is at http://utip.gov.utexas.edu/Video/Roskilde%20PK%20Keynote%20JG.WAV)
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