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SUSPENDED TELEOLOGIES On the Political Economy Roots of the 2007 2009 Subprime Crisis By LUCAS BALLESTIN A Thesis Submitted to the Division of Social Sciences New College of Florida in partial fulfillment of the requirements for the degree Bachelor of Arts Under the Sponsorship of Dr. Tarron Khemraj Sarasota, Florida April, 2013
ii Acknowledgements This thesis is dedicated to my family, my friends, and my professors. Thank you for keeping me grounded and pushing me fore ver forward Special thanks to my editors and committee for locating the promising ideas buried within the calamity of my prose. VESTIGIA NULLA RETRORSUM
iii Table of Contents I. Prolegomena Page 2 II. Chapter 1: The Search for Answers Page 9 Fina ncial Deregulation Page 10 Excessive Risk Page 16 Faulty Corporate Governance Page 23 Fragmented Government Response Page 25 III. Chapter 2: The Theoretical Backdrop Page 29 Free dom and Development Page 29 Sp ecter of Smith Page 33 Against Restraint Page 42 Friedrich Augus t Hayek Page 47 Enigma of Creative Destruction Page 49 M odeling Ideologies Page 53 Managing Risk Page 58 Principles of Self Regulation Page 61 IV. Chapter 3: Chicago on the Rise Page 66 Historical Page 66 Lobby ing Once Popular Page 73 V. Chapter 4: Skin in the Game Page 79 Details of Free Market Ideology Page 79 Po licy Prescriptions Page 86
iv SUSPENDED TELEOLO GIES Lucas Ballestin New College of Florida, 2013 ABSTRACT This thesis helps rectify the underrepresentation of historically and ideologically oriented analyses of the 2007 2009 US Financial Crisis. Faced with the difficult task of retrospectively identifying some of the key causes of the crisis, economists have tended to look at the actions of large banking and government institutions. This thesis investigates not merely the specific policies that generated the catastrophic Great Recession, but als o the ideological justifications that served as the foundation for their implementation. In order to conduct this investigation this thesis examines the most salient elements of economic theory, as well as most important episodes of political influence upo n government policy on the part of the business and economics communities. Locating such elements of theory and moments of influence as the condition for the wave of de regulatory policies of the 1980s, this thesis clarifies the ideological roots of the 20 07 2009 US Financial Crisis. Dr. Tarron Khemraj Division of Social Sciences
1 "A study of the history of opinion is a necessary preliminary to the emancipation of the mind" "Our criticism of the accepted classical theory of economics has consiste d not so much in finding logical flaws in its analysis as in pointing out that its tacit assumptions are seldom or never satisfied with the result that it cannot solve the economic problems of the actual world." John Maynard Keynes, CB, FBA
2 Prole gomena Economic systems typically posit some preliminary assumptions on which certain models operate. These are the foundation upon models seeking to explain real life phenomena are built. Similarly to any discipline whose rhetoric replicates this struct ure, the descriptions and prescriptions of economic models are undermined if their founding assumptions are discredited. So for instance, if we were to observe a mountain of psychological evidence indicating that men and women do not actually base their de cisions off a comparative decision to maximize their benefits, many economic models would cease to hold as much sway. Thus, the assumptions made by economic theorists are extremely important to the livelihood of their models. Ironically, economic theorist s have rarely taken the time to include systematic defenses of their assumptions as part of the package containing their model. Of course some of the best economists of all time have, but this meddling is usually left to philosophers and psychologists to d eal with. Passing philosophical and psychological explanations through the gauntlet of empirical verification, economists exploit the winners and dispose of the losers. Framing their assumptions as empirically verified nodes of theory, the economic theoris t moves along to get their hands dirty tracing out their particular relationships of interest. As I have mentioned just before, economists borrowed their starting assumptions from other disciplines. This is most always the case before the relatively recen t advent of
3 the behavioral economist. In fact, one may argue that any body of systematized knowledge is constructed wholly upon philosophical assumptions. As John Maynard Keynes once put it: "The ideas of economists and political philosophers, both when th ey are right and when they are wrong are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually slaves of some defunct eco nomist." 1 But, unfortunately, I do not have the time or space to discuss that herein. Rather, the aim of this thesis is to disclose the philosophical presuppositions of some dominant strands of economic theory and bring to the reader the recognition that t here is a strong connection between the character of these founding philosophical assumptions and the realization of these economic models, in the guise of policy, in the most recent Great Recession. In other words, this thesis discloses the financial cris es of 2008 not as a hiccup but rather as the result of the popularization of strict laissez faire (or free market) social philosophy. 1 John Maynard Keynes, The General Theory of Employment, Interest, and Money, (New York: Harcourt, 1965).
4 Before preceding any further, it is important to make the following point. The laissez faire school of economics does not exist as such. One does not find in it a unified body of theory bearing an internal harmony and confluence of prescriptions. Instead, one may discern a loose but essentially interconnected constellation of thinkers and models that often differ in their ass umptions and formalizations and even appear internally contradictory or mutually exclusive. Yet there is reason why one is justified in referring to them in the collective singular is that despite these difference. Even in the presence of incompatibility, the laissez faire schools of economic thought fed upon one another and invited policymakers to take similar steps in their routine decisions. Or at least this was the way politicians interpreted things. This chapter brings forward a sketch of a constella tion or collection of parallel research projects which are guided by similar ideological principles. These principles being the protection of individual liberty vis a vis collective valuations and the advancement of a fundamentally conservative socio econo mic position. Twentieth century laissez faire thought represents an impressive achievement, insofar as it develops a complex position on questions of philosophical and historical heft far beyond anything that had come before it or has emerged since. Going beyond beginning assumptions, laissez faire social and economic philosophy takes up its own presuppositions as a yield of its analyses. Simply put, this strand of social economic thoughts represents a particular world view. It represents a world view whic h goes beyond the jurisdiction of the market or, perhaps on the contrary, it seeks to raise market
5 principles of human rationality and liberty to the level of universal transcendental values of human being. Thought in this way, free market philosophy repr esents a particular world view. This is a worldview that has had an important impact upon the course of the past and present centuries. Taken even by itself, this constellation of theory stands as testament to the relevance and transformative power that ph ilosophical work, especially of political economic flavor, can have upon us. This is the phenomenon that this thesis investigates. It is by means of an in depth examination utilizing both economic and philosophical tools and crucial primary texts that thi s author discloses the character and constitution of the 20th century laissez faire world view. By consulting these texts, this chapter lays out the basics of the laissez faire philosophical position, together with its economic implications. An apt place to begin our discussion both chronologically and thematically is Adam Smith's invention of the "invisible hand" of capitalist production. This novelty of theory provided the basic structure that later economists would exploit and build upon. Despite the f act that much confusion surrounds this particular concept, the concept itself is an astoundingly simple and bold solution to questions of economic theodicy. Faced with issues of socio economic disparity between the capitalist and the employee, Smith argued that the most efficient way to assist society as a whole was, paradoxically, for each private individual to pursue his own private interests. Smith's conception of the capitalist market involved relatively small firms constantly under the urgent pressure to compete with similar firms for the customers' business.
6 Adam Smith's vision, and the vision of the whole classical tradition which has succeeded him, revolved around a society of economic agents with unequal purchasing power but relatively equitable, or at least comparable bargaining power. For this to be necessary, strong institutions were necessary to foster the conditions under which a healthy, dynamic market would arise. In that market, all agents, both consumers and producers, were price takers. T his meant that no firm or consumer could by their individual action affect the price of goods and services. It was antithetical to Smiths vision to have a situation in which a few firms or individuals could get the upper hand over their competitors consist ently enough to amass such oligopolistic or monopolistic power. In later capitalist development, large firms came to posses disproportionate amounts or power in the market, and became less of price takers through their ability to manipulate the market by manufacturing demand through marketing and other mechanisms. This stands against Smith on two counts: firstly, that larger powerful firms would distort and manipulate the market in order to decrease the urgency of adaptation to the market's demands, this w orks against competition. Secondly, this distortion obviously works to the benefit of those involved with those large firms, this goes against the invisible hand. The concept of the invisible hand, which implied a capitalist arrangement in which the pursui t of self beneficial motives would end up benefiting society as a whole is in many ways the foundation of neoclassical economics. But the paradox arises in late capitalism, as this question implies, when it is in the interest of large oligopolistic firms t o distort the most fundamental market principles.
7 According to many thinkers within and outside of economics, the roots of the subprime crisis grew out of the efficient market hypothesis. The dogmatic belief that financial markets and the economy at large would act rationally and thus would be self regulating led to an explosion in the criticism of market regulations in the nineteen seventies and nineteen eighties. As a result of this New Classical push, the US government either removed laws disabling risk y moves by markets, leaving the regulation to the regulated, or alternatively severely cut regulators off from the funding needed to correctly carry out their task. The long time director of the Federal Reserve, Alan Greenspan, had himself bought into this popular neoliberal impulse within the economics profes sion and failed to properly enfor ced regulatory measures which may have served to curve the risks associated with much of the rent seeking behavior of firms. Despite later admitting to the shortcomings of the non interventionist model he had so carefully followed before a congressional hearing, Alan Greenspan continues to be a hero to many who see his relaxation of federal regulations as an encouragement to business activity and overall prosperity. In short, the efficient market hypothesis was either mobilized towards the political end of de regulating markets, or it served to justify their deregulation. This pressure led to the removal of laws and committees that had served as obstacles to risky behavi or, under the expectation that in the absence of government regulation markets would regulate themselves. In turn, this lack of regulation combined with a prominent lack of self regulation led to increasingly risky investments which according to the effici ent market hypothesis were unsustainable. And indeed, in the end, the whole thing turned
8 into a catastrophe as one sector of the economy tanked and took another one with it, in a calamitous chain reaction which formed the basis of the current prolonged rec ession. The roots of the current trough in the economic cycle, though, is almost entirely ideological. This political economy thesis reduces the laissez faire school of economic thought to its lowest philosophical denominators. Having exposed the philosop hical underpinnings behind neoliberal social theory and the policies which sprung forth from it, this thesis performs a philosophical intervention into the ideological operators imbedded within free market economic theory in order to clarify the sources of economic discord which culminated in the 2008 Sub prime crisis. Finally, this thesis draws on this clarification to prescribe important reforms to both government and financial industry policy to prevent a similar crisis from occurring again.
9 Chapter 1: The Search for Answers The Great Recession of the last decade lasted just over a year. To the average worker in the United States, however, this would seem like a significant underestimation of what has come to be called the worst economic cont raction since the Great Depression. But although the actual economic contraction lasted 16 months, its effects have been deeply felt. Its immediate effects have shaken the confidence of many consumers, investors and firms. But perhaps most importantly for the academic, the last recession, in its full horror, provided the excuse for an intellectual inquisition into key aspects of both policy and theory in the United States and worldwide. This chapter describes the extent of the crisis before providing a brie f review of the major causes of this Great Recession. The 2008 Recession's period of contraction ran from December of 2007 until April of 2009 when measured by United States GDP Statistics. 2 And yet although this would be the place for this author to writ e an introduction, that introduction is best left unwritten. In its stead are found the experiences of millions of Americans who have found themselves at the mercy of a system whose logic remains still somewhat obscure. The impact of this Great Recession, or how Reinhart and Rogoff have termed it numerous times: The Second Great Contraction, has been impossible to avoid by anyone old enough to recognize its impacts. 2 The Federal Reserve Bank of St. Louis, FRED website, http://research.stlouisfed.org/fred2/graph/?id=GDPC1
10 Yet unlike many natural disasters, the Great Recession was avoidable. The fact that it hap pened, however, arouses in all an interest to discern exactly how it is that this last crisis came to pass. This chapter focuses on four thematic aspects of the crisis and considers them in turn, in order to facilitate the understanding which has escaped m any even unto this date. Financial Deregulation and "Shadow Banking" As the authors of the Financial Crisis Inquiry Commission Report wrote, "the sentries were not at their posts, in no small part due to the widely accepted faith in the self correcting nature of the markets and the ability of financial institutions to effectively police themselves." 3 And as was already cleverly pointed our by the report authors, the fact that regulators were not performing their duties at the utmost is entangled in a his torical and philosophical question of the self regulation of markets and whether or not there should even be a place for government regulators in everyday market operations. The theme of ideological underpinnings to this latest crisis in an important one, and being the main topic at issue in this thesis, is addressed more thoroughly in a succeeding chapter. This section chooses instead to focus on the exact legal and financial dynamics of government deregulation. The first item of the agenda is the distinc tion between commercial and investment banks. Commercial banks utilize their depositors' money in order to lend to other individuals or small businesses. As a reward for allowing their deposits to sit in the hands 3 Financial Crisis Inquiry Commission Report, p. xviii. Emphasis mine.
11 of the bank and be lent out to others, dep ositors receive an interest rate. Unlike investment banks, commercial banks were not allowed by law to use their depositors' money to make risky investments, such as playing the stock market. Following this distinction, commercial banks were referred to as "Savings and Loans" (S&L) by federal authorities and those in the industry. 4 Conversely, investment banks were allowed by law to take their deposits and make more aggressive investments with the aim of yielding a higher return. Traditionally, these banks serviced those consumers who had a significantly larger amount of capital to mobilize and invest. This distinction had been legally formalized by the Glass Steagall Act, which also established the Federal Deposit Insurance Corporation (FDIC). This institut ion insured bank deposits up to a certain figure, which was adjusted upwards over the decades but began at $2,500 in 1933. 5 The creation of the FDIC complimented the formation of the Federal Reserve, which in acting as a lender of last resort, was intended to avoid the feverish bank runs which had taken place in the United States in 1873, 1884, 1890, 1893, 1896 and 1907. What is of particular interest to this investigation is a peculiar provision included in the Glass Steagall act's creation of the FDIC. K nown to insiders as "Regulation Q," and it deserves a good deal of attention. Regulation Q allowed the Federal Reserve to cap the interest rates that commercial (S&L) banks insured by the FDIC could pay depositors. 6 This rule was meant to stabilize the ind ustry, by insuring that competition for deposits did not get out of hand. There is already within the economist's consciousness a certain discomfort with the idea of any sort of cap. And this cap is no different. For this 4 Ibid, 29. 5 Ibid, 29. 6 Ibid, 29.
12 system was indeed stable just as l ong as the real interest rate remained relatively steady vis a vis the nominal cap. By the time the 1960's rolled around, though, inflation had begun to push the interest rates upward. Though interest rates paid on overnight loans between banks had never e xceeded 6 percent, by 1980 it had reached 20 percent. But being tied up by Regulation Q, banks could not charge above 6 percent. And as the authors of the report phrased it, "this was an untenable bind for the depositary institutions, which could not compe te on the most basic level of the interest rate offered on a deposit." 7 The stage was set for a new species of competitor with whom the S&L entities would have to contend. Such is the cue for the big investment banks. Starting in the 1970's, banks like Me rrill Lynch, Fidelity, Vanguard, and others began to "persuade" consumers to abandon the traditional S&L banks in exchange for higher returns. 8 Following on the heels of the abolition of fixed commissions on stock trades by the Securities and Exchange Comm ission (SEC) in 1975, these firms began to seek out new potential customers to bolster their business. To this end, Wall Street investment banks created money market mutual funds to compete with traditional S&L bank accounts. In practice, this was a excha nge of security for higher profits for both the investment banker and the customers they serviced. Investment banks would take the money from the money market mutual funds and invest it in "short term, safe securities." These securities included treasury b onds and the most highly rated corporate bonds. 9 It goes without saying that these sorts of financial vehicles yielded much higher interest 7 Ibid, 29. 8 Ibid, 29. 9 Ibid, 30.
13 rates than the average savings account at a traditional bank. As more and more customers began to opt for these new er species of investment vehicles, investment banks sought to make their services as full a replacement as they could become. In 1977, Merrill Lynch even launched its "cash management account" which allowed its holder to write checks. 10 The downside of new accounts was that the same independence that allowed them to have higher interest rates also meant that they were not insured in case of any loss. Customers, it turned out, preferred the higher returns. Especially after the investment banks reassured them that their investments would be well taken care of. 11 Both at the time and in retrospective, the growth in these types of accounts was staggering. According to the FCIC's report, the market for such "commercial paper" multiplied sevenfold in the 1960s, an d then fourfold in the 1970s. Indeed, the advent of these new financial vehicles were greeted as a great opportunity for all parties involved. Investors would see great returns on their money market mutual funds, those firms receiving funds as investments had access to cheaper loans and the Wall Street investment banks who pulled these deals together earned a healthy commission from it all. 12 But these firms' investments were actually were not all as risky as they have been painted to be since the crisis. T hese firms produced different sorts of investments to suit the different sorts of investors. While some funds pursued high risk investments in exchange for higher rewards, some other funds made safer, more conservative, 10 Ibid, 30. 11 Ibid, 30. 12 Ibid, 30.
14 investments. 13 Taken together, all o f these new investment vehicles and policies by investment banks have come to be known as "shadow banking." This ominous name refers to the relationship between these new kinds of banking policies to the more traditional S&L ones. The new Wall Street optio ns developed as a "shadow" of traditional "Main Street" banking. Despite their "shadow" status, these banks steadily gained on more traditional banks, even surpassing them briefly in the year 2000. 14 One of the disadvantages of traditional banking from a c ompetitive standpoint was that since they were regulated, traditional banks had to remain within certain leverage parameters. This was not so for Wall Street banks. Leverage refers to the ratio between assets and equity. In other words, the ratio between t he money put forward by the firm and the money borrowed. For instance, if I buy a car that costs $20,000 and borrow half, my leverage ratio is 1:2 since I have $20,000 worth of stuff (assets) but only $10,000 in equity. While traditional banks' leverage wa s overseen by regulators, the leverage of investment banks was not. This allowed investment banks to do much more with their money at every level by incurring debt and making bigger investments. Making bets with higher leverage was a lot riskier, for if an investment went bad the investor would be left on the hook for the total amount in assets. But these higher levels of leverage did not only multiply losses, but also profits. Traditional banks were therefore at a disadvantage in several aspects and from m any different angles, and the newer Wall 13 Ibid, 30. 14 I bid, 32.
15 Street investment firms continued to burgeon. 15 As one would expect, this led commercial banks to place additional pressure on legislators and regulators to loosen the regulatory burdens preventing them from competi ng with the large investment banks. And on this front there were some significant political victories. In 1980, for instance, regulators lifted the limits on interest rates that traditional banks could charge. Unfortunately, despite the fact that commercia l banks could offer competitive interest rates, their largest assets (30 year fixed rate mortgages) felt pray to inflation over such a long time span and crunched commercial bank returns, limiting their ability to provide higher interest rates to their dep ositors. 16 Taken together with the Wall Street banks' head start, the cause of the traditional bank was, by the 1980s and 1990s, a lost one. In these two decades, almost 3,000 commercial banks failed in the United States. In the past four and a half decades that number had only come out to 243. 17 Yet the authors of the Financial Crisis Inquiry Commission Report wrote that they "do not accept the view that regulators lacked the power to protect the financial system. They had ample power in many arenas and t hey chose not to use it." 18 Just to take a couple of examples, the SEC could have required a higher leverage ratio in order to cool down the investment banks. They chose not to do so. And for decades, regulators continued to rate aggressive institutions as safe and secure, which in many cases they were not. They could have indicated this. And yet they chose not to. As the report 15 Ibid, 33. 16 Ibid, 34. 17 Ibid, 36. 18 Ibid, xviii.
16 correctly points out, regulators faced two obstacles. Firstly, they were ideologically and politically constrained in their ability to regulate. Secondly, even when they could have fought to overcome this first condition, they lacked the political will to do so. 19 In the words of Alan Greenspan: "Those of us who support market capitalism in its more competitive forms might argue that u nfettered markets create a degree of wealth that fosters a more civilized existence." 20 The logic behind such statements is explored in Chapter Two of this thesis. Excessive Risk The first section of this chapter consists of a discussion of the deregulat ion of the financial sector of the United States economy from the 1960's until the present time. Keeping in mind the fact that the subject of this thesis is the 2008 Subprime crisis, one would be forced to conclude that the financial deregulation should re sult in that crisis. But this would render an incomplete picture. In order to get a more complete picture it is necessary in the mind of this author and the authors of the Financial Crisis Inquiry Commission to develop a discussion about the excessive risk s that were taken by Wall Street firms in the years preceding the crisis. Only when these excessive risks are taken into account does the de regulation of the financial industry become relevant enough to warrant discussion. As a point of clarification, ec onomic talk of "risk" refers to the degree of 19 Ibid, xviii. 20 Ibid, 34.
17 probability that an investment will go bad. Risk is an important factor in any decision making process from the daily life of the consumer to that of the investor. And as has been mentioned above, Wall Street f irms profited from providing their advice, in the form of brokerage, as to which risks were worth taking. In the years that preceded the current financial crisis, the behavior of investment banks in regards to risk underwent a considerable shift. The mann er in which these firms analyzed risk and then presented it to their clients changed. This change was the structuring and securitizing of risk. The marketing of securities has already been discussed in the first section of this chapter, but it is worth re visiting how these securities were assembled in the first place. The starting point remains the same as it would have been for a traditional bank: The head of a household walks into the S&L bank and petitions the bank for a loan. The loan is required for he or she to finance the purchase of a house which will be made into that family's home. The bank then walks him or her through the loan packages available and signs the mortgage. Thus, the man or woman is lent the money with which to purchase a home and t he bank is secured the interest which will be charged on the borrower's repayment over the period of that loan. Usually this period would be something like thirty years or so. Some of these loans counted in fixed interest rates while others featured adjust able or variable interest rates. Under the old modus operandi, this would have been the end of things. And this provided people with homes and banks with some income so that everyone benefited from the transaction. At the same time, the risk was manageable for if the new homeowner found him or herself unable to pay their loan
18 back, the loss to the bank was limited to that particular loan. And while the risk was low and manageable, the profits from these sorts of deals were relatively modest. The innovation of the big investment banks came with the idea of bundling a number of such loans together. What the S&L bank which made the original loan owns, more than anything, is the right to the borrower's monthly payments. There is nothing that ties that ownership necessarily to that one particular house. And as with any other property within a capitalist system, it can be bought and sold. So what took place was that large investment banks would purchase enormous quantities of these mortgages. 21 In fact, they were p urchasing the right to a stream of payments which included a principal plus interest. These bundles of loans were packaged into different "tranches" in accordance with their defining characteristics. Some tranches would include safe loans while others risk ier loans. This was itself determined by a number of crucial rating agencies that would place grades on each bundle in accordance to their assessment of the risks inherent in each. 22 The investment banks would then sell these securities to their clients, wh o would choose from among the tranches and obtain the rights to the monthly payments of homeowners all across the United States. When these homeowners would pay their monthly installments then, their money would no longer go to their local S&L bank but to investors all across the world. These are the mechanics of the mortgage backed securities (MBS) which made, and eventually broke, Wall Street's profit frenzy in the first years of the new century. As these sorts of activities became common place, investme nt banks began to 21 Ibid, 42. 22 Ibid 73.
19 utilize these securities as mock banking services while remaining outside the regulatory framework with which S&L banks had to deal. 23 This gave banks new ways of both making loans and selling securities. As the FCIC report says: "where ba nks traditionally took money fro deposits to make loans and held them until maturity, banks now used money from the capital markets often from money market mutual funds to make loans, packaging them into securities to sell to investors." 24 And since the re was a market presence of rating agencies which assessed the risk of each bundle of securities before they were sold to investors, investment firms made a significant profit from this bundling service, purchasing the rights to these mortgages from small banks and then re packaging them as securities for sale by investors. This was the birth of the Collateralized Debt Obligation (CDO) which was the source of so much Wall Street profit. Again, the profit margin here is quite significant, because neither Wal l Street firms nor investors are the ones actually making these loans, the S&Ls are still the ones doing the loaning. But these loans are then being purchased, evaluated for risk, bundled, and then sold at a profit. The securities earned higher fees becaus e they were taken to be more valuable than the underlying loans insofar as they were customized to the investor's needs by the investment firms. CDOs were customized to fit investor's needs, were internally diversified and could be very easily traded. 25 Co mmercial banks also benefited, however, because the sale of their right to mortgage payments allowed them to move those items off their books and thereafter reduce the amount of cash they had to hold as protection against a panicked run. Thus, 23 Ibid, 42. 24 Ibid, 42. 25 Ibid, 43.
20 ironically, investment banks' activities allowed both themselves and traditional S&L commercial banks to skirt regulations. This was supposed to achieve the impossible: create a vehicle that would deliver higher profits with lower risk. A depiction of exactly how tha t was supposed to happen follows. The "private securitizations," also known as "structured finance securities," brought the benefits of pooling and tranching. If many loans were pooled into one security, then the risk is theoretically reduced since one loa n going bad has a much more diminished effect. Using this logic, the larger the pool, the safer the bet. Securities could also be divvied up into slices, called tranches, and customized in terms of risk and sort of loan. 26 It's necessary to note that not al l loans were mortgages as student loans and other loans made up an increasingly large proportion of loans. Riskier investors could pursue riskier tranches and more modest investors could then do otherwise. On this point it is necessary to consult papers s uch as the one presented by William C. Dudley of Goldman Sachs and R. Glenn Hubbard of Columbia Business School. Papers such as this one endeavored to clarify and above all demonstrate that securitization and structuring of debt would result in a more stab le financial sector. 27 One of the ways in which firms were able to make a convincing case of the diffusion of risk was the creation of "Value at Risk" (VaR) models. These models, developed by the flourishing contingents of quantitative analysts ("Quants") w hich systematically mathematized and computerized Wall Street, relied on historical patterns and complex projections in order to produce risk indexes. With these risk index models, quants were 26 Ibid, 43. 27 Willian C. Dudley and Glenn Hubbard, How Capital Markets Enhance Economic Performance and Facili tate Job Creation, (New York: Global Markets Institute, Goldman Sachs, November 2004).
21 able to predict how much the firm would lose given a change in price. This was all predicated, however, on the ability of predictions to be made using historical data. Making economic projections based on historical data has proven to be a difficult task for economists. This case was no different. For MBSs, the models would prove to be "woefully inadequate." 28 In his discussions with the FCIC, former Fed Chairman Paul Volcker noted that throughout the 1980s regulators began to notice Wall Street banks were beginning to neglect the quality of the loans they were packagi ng since they were selling them rather than keeping them on their books. 29 And as the financial vehicles into which loans were packaged became more and more complex, regulators began to rely on banks to police themselves, effectively realizing the neolibera l notion of self regulation in rational markets. 30 The true horror began when firms began to structure securities which included bundles from different tranches and pursue sub prime loans in exchange for higher profits. As Fed observers had feared, the fa ct that bundles of loans were not being kept on the books for very long did not encourage firms to be careful with the securitization of those loans. This happened in two ways. Firstly, banks actually began to prefer risky "sub prime" loans for their hig her profits. This developed into what has since been termed as "predatory lending." These loans were purposefully made to people who could not afford to re pay them, since those loans would be sold a long time before any signs of trouble would arise for th e issuer. 28 Financial Crisis Inquiry Commission Report, 44. 29 Ibid, 44. 30 Ibid, 45.
22 Eventually, the housing bubble consisting of artificially inflated prices popped and the corresponding MBS were instantly transformed from hot investment vehicle to toxic asset. 31 Secondly, Wall Street firms began to sell securities whose rating was either increasingly meaningless, or whose bundles had been drawn from different risk trenches, thereby resulting in a volatile mix. 32 The first subset of cases included those securities whose risk rating, which ranged from "AAA" to "BB" were not an acc urate reflection of those securities' risk profiles. As has been discussed above, Wall Street rating agencies received hefty recompense for providing their partner firms with good ratings for their products. In due time, of course, those ratings began to b ecome more unrealistic as the pressure to continue to bring in profitable business overcame integrity. In their eventual testimonials, rating agency executives would say that their firms' ratings were nothing more than mere "opinions" and did not have any objective grounding. 33 The second subset of cases includes the packing of MBS from different risk tranches. As one could easily conclude, this would raise the risk profile, especially when the previous two factors of faulty risk ratings and predatory lendin g are thrown in the mix. Since these banks were leveraged up to begin with, any small drop in their value would have disastrous results for their own asset base. Thus, the issue of faulty risk management becomes exacerbated as quality of loans is sacrific ed for quantity and banks leverage themselves in an effort to inflate their influence and profits. The combination of the aforementioned factors landed Wall Street investment banks in an unavoidably 31 Inside Job. DVD. Directed by Charles Ferguson. New York: Sony Pictures Classics, 2010. 32 Marg in Call. DVD. Directed by J. C. Chandor. Santa Monica, CA: Lions Gate Entertainment, 2011. 33 Inside Job. DVD. Directed by Charles Ferguson. New York: Sony Pictures Classics, 2010.
23 precarious position after a few years of having adopted t he risk management policies discussed in this section. Faulty Corporate Governance, Rating agencies, and Due diligence One of the major conclusions of the FCIC report was that the subprime crisis of the late 2000s was a "dramatic" failure of corporate g overnance. 34 Alongside the failure of regulators, the role of policies internal to large investment firms deserve to be touched upon. In order to set up the category of corporate governance failure, it is essential to develop two connected observations. The first is that corporations are expected to act rationally. This assumes as a bare fact that firms would never pursue policies which could potentially lead to their demise, or possibly worse, a serious loss of money. The second is that firms will self corr ect upon discovering any failure of the market. Exactly how this is conceptually possible is clarified in detail in Chapter 2 of this thesis. Working with these expectations, which are themselves drawn from the popular models of firms and markets within t he neoclassical economists' framework, students of the crisis are bound to meet with disappointment. For the view that firms would shield themselves from excessive risk in an instinct of self preservation did not match reality. And since these were indeed the expectations of firm behavior, regulatory oversight had been debilitated and deliberate interventions all but abandoned. Rather, Wall Street firms acted in a way which constitutes a complete departure from the neoclassical models of efficiency and rat ionality in markets. These firms, 34 Financial Crisis Inquiry Commission Report, xviii.
24 especially investment banks, took on great deals of excessive risk and did so with little capital of their own. 35 As the FCIC report authors correctly indicated, Wall Street firms actively increased their risky activities i n direct proportion to the profits they stood to reap by packaging sub prime loans and relying on short term loans. 36 But the problem can be brought down to even a grammatical level, with the category of "risk management." In the context of market lending and investment, there really never was a neutral category of risk management. That is, risk management as such can not refer to an objective, disinterested task to be managed. When speaking in the context of a network of firms vying for profit and investor s, the businesses of risk management was always already, inherently, politicized in terms of profits. And it proves insensible to approach risk management with the expectation that firms see it as just that. And this failure of analysis did eventually beco me evident. For a firm, the issue of risk management is ultimately defined by the horizon of profit that defines the issue of risk. Since a firm's management is trained from their very hiring to think in terms of profits, would measure risk in terms of pr ofit as well. These two issues are inseparable. And as we have seen, the higher the risk the higher the profits. So for the risk analyst, there would loom a constant pressure to accommodate for profits within his or her analysis. Not being able to separate risk management from indispensable profit seeking, the self regulating faculty of these firms predictably became susceptible to measuring risk in terms of profits and folding to the pressure to open the way for their peers and superiors to maximize their profits in the short term. Thus, the independence of 35 Ibid, xviii. 36 Ibid, xix.
25 risk management was lost and risk management gradually became risk justification. As a result of this, the institutions in question expanded at an aggressive rate, especially in ways which made effectiv e risk assessment and even ordinary management difficult. 37 In due time, too big to fail would become too big to manage effectively. Both investment firms and their auxiliary rating agencies developed an over reliance on complex mathematical models which we re truly understood by very few of their staff. Therefore, model output predictions replaced human judgment in investment decisions. At the same time, compensation systems made in this environment of easy money and intense competition tended to reward quic k, short term gains over long periods of proved performance. 38 This encouraged big bets and little foresight, a terrible recipe. When taken together, these policies and trends, whether implicit or explicit, amounted to a veritable failure of Wall Street cor porate governance. Fragmented Government Response The current economic downturn cannot be understood merely by examining the risky behaviors and failures of corporate governance. The atrophied organs of government responsible for oversight, regulation and response must also be included in our analysis. This section considers the government aspects of the financial crisis. As the financial sector continued to burgeon during the 1990s, regulators did take note of the increasingly abusive loans and practic es that kept Wall Street firms going. Unfortunately, 37 Ibid, xix. 38 Ibid, xix.
26 they did not count with the necessary regulations to respond consistently or at the federal level on behalf of borrowers. 39 The most basic problem facing regulators was exactly which regulatory bodies he ld authorization to regulate Wall Street. The state regulators, the Fed and the FDIC were responsible for the regulation of state activity. These bodies were tasked with supervising local mortgage practices. 40 As far as federal regulators, the most obvious candidate was the Office of the Comptroller of the Currency (OCC), which was tasked with supervising national banks. Some agencies, such as the Office of Thrift Supervision (OTS), were responsible for the thrifts. Otherwise, certain governmental bodies wer e responsible for the charting or licensing of brokers but did not supervise those brokers that they registered. 41 Despite these facts, the Fed was unambiguously within its jurisdiction to supervise bank holding companies. 42 The Fed had accepted that role w hen it implemented the Truth in Lending Act of 1968 through "Regulation Z." Unfortunately, the Fed had a mandate to supervise bank holding companies, but there was some ambiguity as whether or not the Fed could supervise non bank lenders of the sort exami ned in this thesis. Again, the Fed had a legal mandate to supervise bank lender and their non bank subsidiaries. And the Federal Trade Commission (FTC) had been given authority by congress to protect consumers as per the Truth in Lending act in regard to n on bank lenders. Although the FTC did bring some cases against non bank lenders, its leaders 39 Ibid, 75. 40 Ibid. 41 Ibid. 42 Ibid.
27 expressed concern that the FTC's staff and structure was not "commensurate" with its legal mandate. 43 On the other side of things, directors at the Fed also express ed a certain degree of confusion concerning the issue of regulating non bank lenders. 44 Fed staff were worried, it is reported to the FCIC, that they would be overstepping their own mandate and interfering with the FTC, whose mandate had been handed to them directly by Congress. While there was an unquestionable sense of responsibility as to the need to oversee and regulate non bank lenders, the impetus was clouded by a lack of clarity as to the Fed's legal responsibilities vis a vis similar regulatory bodie s. As a result of this, the Fed would not exert any authority in respect to non bank lenders until the housing bubble had already burst. By this time however, it was too late to make any significant headway in terms of correcting years of risky bets, bad r atings and irresponsible brokering. In 1994, the legal landscape was somewhat clarified by the Home Ownership and Equity Protection Act (HOEPA). This act was passed in response to growing concern about predatory lending in the 1990s, especially amongst lo w income borrowers. And though the Fed did conduct one investigation that included hearings and all, it did not press very much into subprime lending practices of non bank entities. 45 As the FCIC authors write in their report, in 1998 the Fed formalize its non interventionist policy of "not conducting consumer compliance examinations of nonbank subsidiaries of bank holding companies." 46 This move would later come under criticism for lack of regulatory oversight. 43 Ibid. 44 Ibid. 45 Ibid, 76. 46 Ibid, 77.
28 This sort of behavior should hardly come as a surprise, though, when one considers the "traditional reluctance to support substantive limitations on market behavior..." 47 Indeed, the ruling climate of the decades directly preceding was that of utmost non interventionism. Not just within the Fed, but al l throughout government and especially within the halls of academia. Regulation was seen as not only unnecessary, but detrimental to a well functioning economy Even some of the greatest regulators in the Unites States government expressed opinions that in light of the recent crises strike one as negligent and bordering on the criminal. For instance, one may take Alan Greenspan's infamous comment to Brooksley Born, former chairperson of the Commodity Futures Trading Commission (CFTC) in the 1990s. What foll ows in an excerpt from a relevant PBS Frontline special report transcript: Greenspan: "Well, Brooksley, we're never going to agree on fraud." And she said, "Well, what do you mean?" And he said, "`You probably think there should be rules against it." And she said, "Well, yes, I do." He said, you know, "I think the market will figure it out and take care of the fraudsters." 48 The logic behind Greenspan's remark, and the United States government's fragmented and unwilling response to bad corporate governance excessive risk, and predatory policies will be the subject of the following chapter, in which the ideology of neoliberal non regulation is carefully considered. 47 Ibid. 48 Pete McCormack, "Brooksley Born and Alan Greenspan: The Warning That Was Ignored by the Banksters and the Fraudsters," Pete McCormack, entr y posted November 1, 2009, http://www.petemccormack.com/blog/?p=1568 (accessed March 25, 2013).
29 Chapter 2: The Ideological Backdrop or; the Theoretical Foundations of Neoliberal Economics As with all modern financial crises, the story of the Great Recession begins with the rise of industrial capitalism in the eighteenth century. At least since the industrial revolution, capitalism has exercised hegemony in the Western world. Any temporary exception has served to strengthen this hegemony and not to weaken it. All of this is hardly up for dispute. This being the case, this is hardly all that interesting. What is interesting to the historian of economic theory is the ways in which capitalist principles of social organization have manifested themselves during different times and locales. Even more interesting is the manner in which economic theorists have approached the capitalist system in different times and locales. This chapter takes a lo ok at the way in which free market proponents made their case for increasingly limited controls and regulation. Freedom and Development (in That Order) A brief historical perspective is helpful to understand the workings of laissez faire ideology. For m any of the most important contributors to economic theory saw history as the development of human freedom. In this narrative of progress, our current historical period is seen as the freest of the epochs, especially in contrast to the major historical peri od directly preceding modernity, that is, the middle ages. And the significance of the
30 middle ages for the economic historian is the feudal system of social organization, whereby the means of production were owned by a class of nobles who usually rented th ese mills and other instruments to a class of serfs which were chained either to the land or to the nobleman. This, roughly speaking, is the system which dominated the middle ages. Guided by the principles of individual freedom of mobility and action, mode rn observers were horrified at the stark inequities of the past and ever thankful for their having been ended. And it was capitalism which ended it. It was under capitalism that the repressed and malnourished creative capabilities of ordinary people were f inally unleashed upon a world which desperately needed it. With the asphyxiating failures of mercantilism, sovereign protectionism had to give way to the free market to go about its business unencumbered. Or so goes the traditional story. But anyone who h as delved into the historical record realizes that the transition from feudalism, through mercantilism and ultimately into capitalism was nowhere as neat as this. And thankfully for the free market advocate, these layered changes cannot be attributed who lly to capitalism, since it was these very layered changes that brought capitalism into place. Logically, it cannot be said that capitalism was its own cause, so one must look for the cause of the shift elsewhere. I say thankfully precisely because the abs urdity of an ex nihilo narrative of capitalist development provides the ground for a more nuanced understanding of the capitalist origin. And when one says origin, it means both historical and conceptual. Even before the industrial revolution galvanized ca pitalism as the new social order, there existed class tensions between the olden aristocratic and the newer
31 commercial classes. In order to understand how the commercial classes were fomented at a time where feudalism was the norm one must draw a distinct ion between social arrangements in the country vis a vis the medieval city. The cities of northern Europe became the home of free men and women. As the old German saying goes, Stadt Luft macht Frei ." 49 And it was in these medieval cities that merchants set tled. Or, on the contrary, it was on the trade routes of merchants that cities grew. The connection between trade and urbanity in middle ages is a subject deserving of its own extensive discussion and it cannot be properly elaborated here. Suffice it to sa y that the shift from feudalism to capitalism was to a significant degree driven by frictions between an increasingly wealthy and thus more influential class of merchants and an increasingly poor and decreasingly influential class of aristocrats who were b arred from competing with the merchants by aristocratic lore. Evidence of this struggle between the urbanite merchants and their aristocratic counterparts can even be discerned in the economic canon. The writings of Ricardo, for instance, have many times b een interpreted as the efforts of a merchant born intellectual on behalf of his class and against the "rent seeking" landowners. 50 Delving deeper behind this thinly veiled staging out of class conflict there is an undercurrent of a more ideological change. The position taken by the free merchants who would eventually triumph over the landowning elite was that men should count upon liberty to acquire and exchange property freely, not to mention move about freely and 49 Caroline Goodson, Anne E. Lester and Carol Synes eds. Cities, Texts and Social Networks 400 1500 ( Burlington, VT: Ashgate Publishing Ltd, 2010), 279. 50 Mark Blaug, Economic Theory in Retrospect 5 th ed., (Cambridge: Cambridge University Press, 1997), 76, 112
32 work at the enterprise of his own choice. For many historians and certainly for the free market advocates of the last century, this was the decisive factor in the eventual victory of the capitalist mode of production. The tremendous productive capabilities unleashed by private property notwithsta nding, the true origin of capitalism are the principles of classical liberalism. As listed by F. A. Hayek in his Constitution of Liberty these are: proper legal status within the community, immunity from arbitrary arrest, work at whatever one desires, and movement according to one's own choice. 51 These are the principles of liberty which are so often extolled by the twentieth century free market advocate from Ludwig von Mises to Milton Friedman. What one was to find behind the push for capitalism was nothi ng more than the full actualization of the world in accordance to the principles of the Enlightenment. The major themes are everywhere evident: decentralization of power, a turn towards materialism, social contract theory and its classical liberal corollar y, and an emphasis on universal a priori principles of human cognition and behavior. These themes, illuminated in the works of philosophes clustered around Paris and German princes, were brought into fruition by the principles of non coercive mutually ben eficial civil society. The end result of this intellectual historical process was the privileging of the rational, autonomous individual. And once human subjects were 'recognized' as intrinsically rational and free individuals, the economic development of Western Europe accelerated at an astounding rate. Within a few decades of the widespread acceptance of 51 Friedrich A. Hayek, The Constitution of Liberty (Chicago: The Chicago University Press, 2011 ), 70.
33 classical liberal principles amongst the most advanced minds of the age and the 'enlightened' despots whom they advised, the fruits of capitalism began to show themselves. An astounding display of individual creativity and collective growth and development followed. The Specter of Smith Capitalism is the astounding belief that the most wickedest of men will do the most wickedest of things for the gre atest good of everyone." Keynes This is a narrative that traces out the contours of free market ideology. But its ability distinguish free market ideology from other currents of thought is very limited. To be sure, there are plenty of meta historical n arratives about the unfolding of liberty and reason throughout the ages. But not all of them came concluded with the development of capitalism. Marxist thought, to take a significant example, evolved out of similar notions of historical progress. It also p osited principles of liberty, rationality and development. And yet Marxist philosophers and economists oppose the free market heartily. So what sets the capitalism apart from other generally humanist oriented persuasions? The answer is that proponents of capitalism fiercely defended the right of private individuals to own and retain property, even if this property is the means of production by which the wider group gained sustenance. More specifically, we see within the proponents of free markets a strong level of consideration of the rights of the individual as taking precedence over the concerns of the collective. Yet it is on this point
34 where one registers a break. Or rather, a split in the capitalist tradition. On one hand one encounters theorists like Ayn Rand, the progenitor of Objectivism and a fierce defender of the right of the most creative and adventurous in society to their rewards. On the more extreme wing of laissez faire advocacy, Rand hosted absolutely no regard for the concern with the coll ective. 52 Ever the independent mind, Rand constantly criticized even those free market advocates who did appeal to a sense of purpose located beyond the individual. And these are the theorists with which this chapter is mostly concerned s imply because they are the most influential. At the root of free market ideology one finds a regard for the fate of the larger collective which mobilizes the freedom of the individual not by forsaking the society in which he or she moves but rather by formulating a new rel ationship between the private individual and the wider collective. This new formulation is nothing other than the invisible hand. This is the mechanism that shall now be explored. Adam Smith thought that the free market, when working correctly, would lea d to great overall improvements in the lot of society as a whole. His prescription, however, was for firms and individuals to pursue their own self interest with little "charitable" regard for the common good. This would result in an apparent contradiction for one could imagine the hellish chaos resulting from the unbridled pursuit of self interest. But Adam Smith's key insight here was elaborated in the concept of the "Invisible hand." 53 This was the social mechanism by which the pursuit of private self in terest would lead to 52 Alan Greenspan, The Age of Turbulence: Adventures in a New World (New York: Penguin Books, 2007), 40. 53 Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, (Hampshire, UK: Harriman House Ltd., 2007), 276.
35 overall public betterment. Smith theorized that since price was a key transmitter of information (a higher price would indicate additional consumer demand for a particular good) and self interested businessmen would be drawn towards th e industries charging the highest prices (hoping to obtain higher profits), the final result would be for ambitious, self interested businessmen would rush to crowd into the industries which would in the final effect bring the highest benefit to society as a whole. Competition would ensure that since men would only pursue their own interest, and every man would do just that, every firm would be forced to keep their prices as low as possible, for fear of being underpriced by a similarly self interested compe titor. This is the part of the market mechanism that we understand as "self regulating." Heilbroner writes that: "a man who permits his self interest to run away with him will find that competitors have slipped in to take his trade away; if he charges too much for his wares or if he refuses to pay as much as everybody else for his workers, he will find himself without buyers in the one case and without employees in the other." 54 Additionally, competitive self interested firms would provide not only a relativ ely uniform rate and price but would also "heed society's demands for the quantities of goods it wants." 55 This explains how it was that Smith figured competition into his theoretical models along with rational self interest, the public good and the "Invisi ble hand." Thus, in an impressive feat of political economy acrobatics, Adam Smith made the point that in a free market concerned citizens needed not lament the fate of the wider public. In a free market, the pursuit of private self interest by the capita list would 54 Robert Heilbron er, The Worldly Philosophers (New York: Touchstone, 1995), 49. 55 Ibid.
36 ultimately result in the benefit of the larger lot much more dramatically than if the capitalist had taken to disingenuously generous philanthropy. And yet the contour of free market theory has not yet come into distinct enough relief. What rem ains unclear is the reason why the capitalist mode of progress is taken to be the best method by which to organize society. The question then becomes: why is capitalism worth fighting for? The missing link is a deep philosophical commitment on the part of free market advocates to the idea that rational self interest inheres in the human agent. For laissez faire advocates, the pursuit of self interest is simply human nature. What this means is that capitalism, in its fostering of self interest as the primar y motivation for social activity, is the most natural social arrangement possible. The consequence of this conviction is twofold. On one side of the coin, capitalism's enormous material success becomes not just the result of greater efficiency, but also of a more humanistic economic creed. This has the effect of effectively moralizing capitalism as the natural outgrowth of human freedom and rationality. On the other side of the coin, any alternative to capitalism is doomed to failure from the start do to no thing less than an irreparable incompatibility with human nature. The first issue is the moralizing of capitalism. Throughout many supposedly dispassionate texts authored by free market advocates one may locate the intertwined threads of raw material effi ciency and idealistic romanticization. This latter element of laissez faire philosophy approaches capitalism as the most coherent realization of the Enlightenment principles mentioned earlier. Capitalism, from this angle, constitutes the
37 most apt real worl d adaptation of principles of liberty and rationality embraced free market advocates. Capitalism is conceived as the system in which the least amount of coercion is allowed. By very definition, free markets enjoy from a lack of government intervention. Go vernment intervention is seen, as will be later discussed, as a distortion of the marketplace. But this is not the coercion which is absent in capitalism. The coercion which is absent in capitalism is that coercion which was present before the widespread a doption of capitalism as the dominant mode of social economic organization (at least in Western Europe and the United States) during the time if the Industrial Revolution. Economic agents of a free market are free to contract, hire, work for, purchase or s ell any of their property. Included within this category is the agent's own time and energies, which he or she may put up for rent on the market. The implication here is a powerful one. Namely, that in a society in which a free market drives the movement o f the economy, no choice is ever coerced. It follows from this that economic agents within capitalism are free to make choices as they see fit and are ultimately subject to the laws of the market. Economic agents are, therefore, free. They are free to do as they please and cease doing so when they no longer see it to be in their benefit. Economic agents own their time, their choices and their lives. In this way liberty makes its fullness and richness manifest. Thus, this decentralization of power and scar city provided by free market competition enables individuals to most rationally approach the most mundane of question in view of the looming problem of scarcity. As any contemporary textbook will
38 instruct, economics takes up the question of limited resourc es and unlimited desires. Starting out with the acknowledgement that it is not possible to satiate all desires, economists address the issue of choice and construct models which formalize the process by which decisions are made by economic agents. And it i s capitalism, say free market advocates, which best embodies this lesson. Capitalism is not an apparatus which creates problems, it is a method of solving problems. Just as any other system of social and economic organization, capitalism may often run to obstacles. Simultaneously, capitalism is portrayed as a way of problematizing reality as such, by re formulating every choice as a choice in the face of finitude. Everyday life within a free market acquires an either/or framework for judging choices. Movi ng forward with the knowledge that every society must deal with the transcendental problem of material human existence, scarcity, the individual social agent is forced to make choices rationally. 56 In this sense, the free market liberates the individual to adopt an thoroughly consequentialist stance in their interactions with the world around them. The result is the development of an eye for optimization. Economic agents are forced to approach the world rationally, to make choices with an eye towards possibl e outcomes and are never allowed to forego the consideration of the long term impact of their choices and the alternatives which they turn down. And there is found the brilliance of the 'self regulating' mechanism inherent in the free market system. Our c hoices are checked by a rational democratic mechanism. Through the deliberate measure of supply and demand forces and their price 56 By rationally, economists usually mean simply in accordance to a cost benefit calculus.
39 determinations, agents in the capitalist economy transmit information about which alternatives are most preferred by them. Whe n these choices are taken in the aggregate, one obtains a detailed report of which goods are services are most readily desired by the public. It is important to continue to emphasize that as a result of the problem of scarcity, these choices are rational c hoices, and thus in their aggregation yield rational aggregate results. Thus, the free marketplace becomes an exuberant manifestation of (consumerist) democracy in action. As the only result of a system of equal and free agents, the market becomes a mecha nism by which to determine the desires of the masses. The capitalist holds no regard for tradition or taboo, if there is demand for a product, he or she will be driven to deliver it at a fair price by his or her need to turn a profit. Should the capitalist not deliver the goods desired by the consumer or deliver them at an unfair price, he or she will be promptly driven out of business by consumers. The consumer will cast a vote with their money, forcing the capitalist to produce in harmony with the desires of the consumer. For Smith, the sense of urgency created by the presence of competing rivals combined with a total inability to control the marketplace would result in an upward trend of ever developing goods and services. In this world, firms would remai n lean and mean. They would be efficient, specialized apparatuses which would be forced to respond to the rapidly changing dynamics of the free market. Smith also despised large firms, such as Joint Stock Companies, which he felt had the ability to distort the markets through a gradual immunity to the pressures of competition. Even further still, the fact that capitalist production is so transparently driven by
40 the profit motive is thought to result in more choices of products than would be present if any other motive was the motivation for production. The logic here being that if he or she believes that a given good or service will turn a profit, the capitalist must produce it. This allows for an enormous variety of different options for each product desir ed. And through the check of inter firm competition, consumers are assured that products will only be offered proportional to the demand for those products. Hence, the free market places constitute one of the purest instantiations of the democratic system accompanying the recognition of human beings as a group of inherently free, sovereign and rational agents. It would prove fruitful to consider one major objection to such a conception of the capitalist democratic marketplace only if to appreciate the free market retort. The possibility should appear obvious for a critique of fundamental choice. This being a gesture made by many anti capitalist critics, who place the emphasis on the different sorts of choices which agents in a capitalist marketplace can mak e. In opposition to the free market perception as developed above, critics of capitalism recognize that while the choice available to the individual within a capitalism economy is indeed more varied in terms of commodities, their choice over more fundament al matters of social organization are totally out of the question. Most commonly, the choice of how the means of production will be administered, the choice of what will be done with the surplus value produced by labor and the choice of whether or not firm s will produce goods which do not turn a profit despite being beneficial or even necessary for the society are raised. In a real democracy, the critics claims, all issues of large import ought to be up for debate, especially the more fundamental questions.
41 The answer to this criticism is quite ingenious and boldly philosophical in nature. Free market advocates argue that the market in which there is a diversity of products widely available and the mode of production of these goods is always at issue is an impossible dream. Private ownership and management of the means of production are the very conditions of possibility, if one will, of a healthy and diverse marketplace. It is only by securing these admittedly fundamental issues in accordance to the princip les of liberty and rational sovereign choice than the benefits of a strong, diverse economy can be expected. This theoretical outlook, in its entirety, can be traced to the founding father of free market advocacy, an eighteenth century Scottish moral phil osopher named Adam Smith. 57 If one takes pause here and returns to the twofold nature of the free market advocate's commitment to capitalism as the natural result of the inherently self interested human being, the question of alternatives to capitalism and their failure begs to be asked. For the free market advocate, any alternative to capitalism is simply incompatible with the inherently free, sovereign and rational agent that has been the focus of the preceding discussion. And this will be the topic of th e following section. 57 As a caveat, I must remark that I will make the argument later in this thesis that the neo liberal reading of Smith is incorrect, and that therefore a corruption of capitalist theory.
42 Against Restraint "Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be." Keynes The determining characteristic of free market advocates is their staunch opposition to government intervention in the marketplace. In order to tease out the ideological reasoning behind this consistent opposition to government intervention, it is necessary to consider the ways in which government intervention in the marketplace impacts th e principles upon which free market theory is built. To this end, a couple of the most commonplace issues of contention will be examined, revealing the ideological kernel of the laissez faire position. The first issue to be considered is that of central p lanning. Central planning, which characterized 'socialist' regimes, is the most utilized modern alternative to the free market. The modes of production in a centrally planned economy produce in strict adherence to centralized government mandates. The benef it of centralized production is that the state can steer the market, via mandate, to produce that is most desperately needed by the nation at that time. The most popular example of central planning are the five year plans that were utilized by the U.S.S.R. to bring the former Russian Empire up to date with its industrialized rivals. Imposing a system of quotas on what is to be produced can carry out central planning and how much of it is to be produced in any given period. Along with the mandate, the centra l committee usually offers both positive and negative incentives to producers.
43 The most traditional criticism of central planning advanced by the advocates of the free market follows. In a centrally planned economy, the demand is exacted not by an aggrega te of the consuming public, but by the state. Thus the demand for goods is distorted by State determination. Since production under this system is the production of the goods privileged by State need rather than consumer desires, the demand for goods suffe rs from a fundamental distortion. Since production targets are set by the state as well, the profit motive is effectively effaced and both the quantity and the quality of produced goods suffer, as the producers' interest in their own production is not maxi mized by profits. Furthermore, central planning effectively undermines competition, resulting in an additional incentive for firms to innovate and improve the quality of their product. Even when explained informally, the logic of the above argument is an economic one. But what is really at stake, subsisting below the surface, is the philosophical commitment to individual liberty, which has already been discussed. What is truly objectionable about central planning, according to free market advocates, is the fundamental restriction of the possibilities of production that comes along with the narrow focus of a few targeted commodities, which are deemed as essential, by the central state. 58 In other words, central planning is mutually exclusive with the free cho ice that goes so lauded in the free market system. Opposed to this choice of production and consumption as determined by individual cost benefit analyses, central planning bars individual choice and replaces it with state mandate. What this mandate actuall y bars, though, is the freedom of choice of both consumers and producers. 58 Friedrich Hayek, The Constitution of Liberty (Chicago: The Chicago University Press, 2011), 62.
44 Next to central planning and often correlative to it, is the option of price setting. In what really should be thought of as an aspect of central planning, price setting refers to t he setting of prices by the state. This can either be done directly setting a preconceived price per unit of a given commodity in accordance to its perceived value to the nation's development or timely predicament. Alternatively, it could also be done by s etting a range within which the price of a commodity may freely float but outside of which it may not be set by firms. From a purely economic perspective, this places undue constraint on firms by fixing their prices, which would ordinarily be set equivale nt to the marginal cost of production. By setting prices, therefore, the state is actually setting a constraint upon costs. And yet, the prices of inputs are not similarly set to a given price. Thus firms are subject to a set price and yet suffer from fluc tuations in their costs. Since by very necessity the prices are set below what would ordinarily be charged, firms are forced to lower their costs accordingly. Obviously, something has got to give way so that the equivalence may be maintained. Thus firms wi ll be forced to decrease either the quality or the quantity of their output. Of course, consumers will bear the burden of this decrease and the price control will backfire. 59 Rather than approaching things from the economic side, things become more urgent when analyzed philosophically. What one observes on the part of free market advocates is a staunch fixation with the ideal of human rationality. For, as I described above, an requisite aspect of the human for the free market advocate is an image of the hum an subject as a reasoned, rational agent. Further, as has been discussed apropos 59 Ibid.
45 Adam Smith, the traditional classical view places prices not just as arbitrary digits conveying and exchange value. Rather, prices are the market's "information transmitters." Through prices, information is conveyed about the cost of production in terms of both capital and labor Also, prices take supply and demand into account. And via supply and demand, prices reference the relative value of the commodity to the community of the market. The true issue, then, is that price setting distorts the information about the commodity delivered to the consumer and jeopardizes their ability to approach their consumption rationally. Not to mention the inexactitude with which measures of a ggregate economic growth, such as GDP, would be taken in an economy in which prices did not reflect the relative value and costs of goods and services but rather aleatory, corrupt bureaucratic whimsy. The issue then, is not lower quality products or an ar tificially depressed economy but the resultant irrationality of market transactions. This may be fine and well, one may think, but real world markets are hardly ever perfectly competitive and free, even when regulation is severely decreased. The facts poi nt to regulation as a measure that prevents excessively disproportional market power. Most real world marketplaces display oligopolistic competition, with some firms having much more market power than others. In such a scenario, uneven market power contort s the playing field, which end up creating its own set of problems. Free market advocates typically do not deny that this is the reality, and that free markets are an ideal instead of a reality. Despite the fact that this admits a gap between the free mar kets envisioned by their advocates and real world markets, this does not
46 weaken the case for free markets. If anything, the case is thereby strengthened. Reinforcing the view of free market advocacy as a moralizing mission, defenders of the free market ide al argue that if agents make their own decisions on the assumptions that markets are free and rational even when they are not, then their decisions will themselves be rational. It is important here to highlight the parallel to moral claims that moral ideal s remain ideals only so long as they are not acted out. If everyone did this, one concludes, then the gap between the ideal and reality would be eliminated. To summarize, interventions upon the market by the state on behalf of the people are not just inef ficient, causing distortions in the market place. They are also immoral, insofar as the y alienate the individual from the basic constitution of his free and rational self. So far, our investigation has served to elucidate the values underpinning free mark et economic theory. By engaging laissez faire economic theory on its own terms, the ideological commitments undercurrent have been brought to light. Namely, these are a belief in the basic autonomy and rationality of the human subject. What is missing, how ever, is a strong and clear enough connection between autonomous and rational subjects and the vast, almost frenetic creative and productive activities unleashed by the capitalist mode of production. This investigation now moves towards clarifying this con nection.
47 Friedrich August Hayek Friedrich August Hayek (1899 1992) was one of the most fierce promoters of the heterodox Austrian School of economics. This school is distinguished by, amongst other traits, its adherence to the principle of free market self regulation and its members' insistence that government interference is exponentially more harmful than helpful. Hayek came to be one of the most influential economic theorists in the time between the two world wars. His writing came to the forefront o f academic debates in the aftermath of catastrophic economic crises. At the closing of the decade, and at least partially as a result of the German hyperinflation problem, the whole world was dragged into what later became known as the Great Depression. 60 Hayek's influence is most acutely felt in the sphere of politics and public discourse, for he was not always taken seriously as an economist. Although Hayek came to be seen as the great rival of John Maynard Keynes during the 1930s, and as an enfant terrib le of the economics profession at the time, his economic theories were ultimately scrapped. It's important to note that this fate resulted not so much from the faultiness of his conceptual technique, but rather from the un verifiability of his descriptions of complex economic phenomena, the mathematical tools for which were not available to Hayek. Despite this, Hayek's devoted emphasis on the supply side of the economic puzzle merited a resurgence in academic interest in his ideas, which came back into fash ion during the nineteen seventies. 61 Hayek's contributions were centered on the relationship between money, interest 60 (During the 1920s, Germany was forced to take measure s against hyperinflation.) 61 Edward Feser, ed., The Cambridge Companion to Hayek, (Cambridge, Cambridge University Press, 2006), 46.
48 rates, and the business cycle. Hayek's monetary theory of the business cycle further developed the insights of Knut Wicksell (1851 1926) an d Ludwig von Mises (1881 1973) in regards to the role that monetary policy had to play in the cycle. 62 The fundamental presupposition laid out by Wicksell and von Mises was the notion of a natural rate of interest. This was the point at which saving and inv estment levels were equal to one another. Arguing from common sense, von Mises wrote that if consumption was too high, then by definition, saving must be too low. Once the "stock of consumption goods" was exhausted, the price of those goods would rise and bring expansion to an end. 63 Any difference between these two would have to be remediated by the creation of money through the banking system. Due to political pressures, however, expansionary monetary policies would always be more popular than contractiona ry policies. The solution, argued von Mises, was a policy of "neutral money." This is the background assumption which is necessary to understand Hayek's own development. Hayek's contribution essentially involved an emphasis upon intertemporality. Hayek's point was that linkages between economic processes occurred in time. Extending the Austrian tradition, Hayek viewed capital in relation to time, that is, the advantage of physical capital is that it allows production to take place over a longer term than l abor alone. Somewhat counter intuitively, Hayek argued that employing physical capital involved a longer timespan than straight away labor. This is because while simple hand tools can be produced quickly, more complex machines, and the machine tools requir ed to make them, take much longer to be produced. For instance, it would actually take less 62 Ibid, 36. 63 Ibid, 37.
49 time, all things considered, to construct a house using only labour and simple basic tools than to do so using a crane and large equipment. The conclusion was that given the same output, entrepreneurs would always choose the more labour intensive process. 64 What this results in, says Hayek, is the consideration of how interest rates factor into such cross temporal investment decisions. When the rates of interest rise, entrepreneurs shift their investments to shorter production processes. When this occurs, the demand for more advanced capital falls off and demand for simpler tools rises. The problem, however, is that it takes time to write off machine tools and produce simpler tools once more. In the resulting time gap, workers who cannot be absorbed by the new production models will lose their jobs. This unemployment would necessarily be temporary, as production would eventually settle to a new set of prices. Thus, con cluded Hayek, economic recessions were a result of intertemporal price distortion resulting from imprudent monetary policy. This is significant today, because Hayek's theory, and theories like it, went a long way to shift the focus from business cycles as a natural aspect of the free market process to business cycles as a result of undue government interference with free market activities. The Enigma of Creative Destruction Another important concept that greatly influenced the free market school of thoug ht, creative destruction, was popularized by another Austrian economist, Joseph Schumpeter (1883 1950). Creative destruction, as Karl Marx and Joseph Schumpeter 64 Ibid, 40.
50 termed it, results from the intersection of specialization and competition. Creative destructio n refers to the manner in which progress in capitalism constantly destroys the conditions of a prior economic order. Schumpeter took up a traditionally Marxist term and re interpreted it. For Schumpeter, capitalism's undeniable material success was in grea t part a result of this creative destruction. For Schumpeter, capitalism was driven in large part by entrepreneurs. These entrepreneurs were attracted to the large wealth accessible to successful capitalists. In order to do this, entrepreneurs create new g oods and services which in some way are an improvement over those already available. Through the creation of a better good or service, the entrepreneur in a way destroys the existing market for the goods and services his innovation replaced. Thus, at the i ntersection of specialization and competition, agents in capitalism are constantly seeking to destroy old markets by creating new ones and profiting from the process. Firms are always looking for the next great good or service which will place them ahead o f their competitors. Through specialization of research and firms, innovations arise that perpetually renew the market. And this is how specialization, competition and creative destruction signify the constant revolutionizing of the economy in capitalism. External forces, such as natural population growth, also contribute the regenerative frenzy within capitalism. As a result of the natural rate of growth in the world, which has trended upwards across societies and history, capitalism has a constant feed o f new persons. These persons are in need of material goods and services and employment just like everybody else. Thus economies, capitalism especially included, have had to grow ever constantly to attempt to provide for these new needs. Through the
51 develop ment of new technologies, and specialization, capitalism has been forced to become lager and more competitive but also more efficient. Again, what distinguishes free market capitalism from other socio economic arrangements is the prevalence of the profit motive. Within capitalism, those who own the capital are constantly seeking to increase their profits. This is not as much of a choice as it is inertia, for without constant growth one risks being out maneuvered by competitors and falling into ruin. As a result, good capitalists are always on the lookout for the next big change in the mode of production that will give them the advantage they desire and require. This change in the mode of production could refer to a more advance piece of equipment, a more s treamlined process, or any other innovation that proves to increase the capitalist's profit margin. The other major feature of capitalism that has drawn the attention of many scholars is the tendency within capitalism to always seek new markets and "acti vity spheres," as David Harvey refers to them. This constant expansion of capitalism is closely entwined with the tendency of capitalism to revolutionize its own conditions of production. In search for new possibilities for higher profits, the capitalists search for new investment possibilities. Although individual capitalists will often specialize in one market they know well, theorists have noted that the larger tendency is for funds to work their way across markets, both domestic and foreign in search o f higher returns. This tendency of creative destruction within capitalism i s, argue free market advocates, nothing other than progress. With each successive generation the tastes and
52 standards of consumers change to some degree. New generations of consume rs will prefer products that are faster, sleeker, more efficient. This is simply due to the fact that people's desire for products are affected by fashion. And as has been discussed above, where there is a desire or demand for something, there is an oppor tunity for profit. There is also a risk involved, admittedly, but in economics and finance risks are usually associated, somewhat counter intuitively, with higher potential returns. The logic behind this relationship is that the valuation of a venture is d irectly correlated with its risk. The more risky a venture becomes, the less incentive anyone has to take part in it. Thus, higher rewards are offered to offset that initial disincentive. Generally, agents will maximize return for any given level of risk o r minimize risk for any given level of return. It is a matter of course that not all economic agents posses the temperament to pursue higher risk investments, preferring instead to opt for higher safety and safer returns. But one can always expect that th ere will be be agents willing to invest in higher risk ventures in pursuit of higher returns. Coming back to the demand aspect of this scenario, one readily can apprehend the opportunity for investors to develop new products, entranced by the potential fo r new and higher streams of revenue. Entranced by that potential, individuals and firms will attempt to tap into products and services for which there is considerable demand, dropping those for which there is not. In this manner, as the demand for products changes from generation to generation and even from year to year, businesses adjust to keep pace with changing tastes and styles. When this instinct to capitalize on changing desires is paired
53 up with the creative destruction of old markets in the creatio n of new ones, the result is steady material and social progress in society. Modeling Ideologies Because the previous models explaining the behavior of economic agents proved insufficient, J. F. Muth and other economists came up with the following equa tion: P = p* + e. Here P represents the equilibrium price, p* represents rational expectations and e represents the margin of error. This formula opened up the theoretical space for rational expectations theory to account for the patterns of prices in fi nancial markets, which resembled a "random walk." 65 The traditional Keynesian prescriptions had proved unable to bring about the desired results, and so economist set themselves to the task of discovering the mechanics of pricing in financial markets. The p oint made in the equation was that economic agents were rational. Keynes had held the belief that expectations were volatile and were not really derived from rationality but from what he termed "animal spirits." 66 The definition of economic agents as ration al had a very particular meaning: firstly that economic agents were always looking to maximize their utility. Secondly, that to the end of maximizing their utility, economic agents constantly sought and incorporated the latest information in order to make the best possible decisions. The educated predictions made by rational agents looking to maximize their utility after 65 A mathematical description of a path resulting from successive random steps. In other words, the movements of prices in the financial markets are random, or unpredictable. 66 Keynes, The General Theory
54 having taken the latest available information into account are expressed in the above equation as p*. The formalization of the theory of r ational economic agents into the rational expectations equation provided the appropriate framework with which to understand the shortcomings of government policies specifically, but also served to give insight in the fundamental mechanics of the behaviors of investors. In this way, rational expectation theory was able to go beyond Keynes by actually discerning a generalizable principle by which investors operated. Rational expectations theory also provided space for error. The third variable in the equation e" left an open space for irregular information, human error and that most fundamental degree of risk that plagues human predictions of the future. Thus, the rational expectations theory has become the popular baseline from which most subsequent mainst ream economic models have taken their cue. The question of appropriateness is a difficult one. For most economists, the image of rationality presented in rational expectations theory has clearly been a great step toward understanding the behavior of econo mic actors within financial and other markets. Rational expectations theory has not gone without criticism, however. The two general positions will be summarized. The idea of rationality contained in this model is acceptable to the extent that it formall y allows room for error. Rational expectations they does not in any way imply that the expectations held by rational economic agents will not be mistaken. In fact, it assumes that some of the time decisions made with even the most up to date information wi ll still lead to unfavorable results. In this way, the theory avoids being destroyed by the common day calamities of the cyclical market. Otherwise, critics could easily assert that
55 judging by the unpredictable nature of the market, its actors could not po ssibly be rational. The theory does not assume, however, that rational actors will not make mistakes. Instead, it just provides a rough sketch of the process by which economic agents will make their decisions. The idea of rationality contained in this mod el is not acceptable to the extent that it does not formalize the nature of the decision making process enough. It is very difficult to truly test the notion of rationally formed expectations. Since we are not privy to the economic decision making process of agents, it is ultimately impossible to indubitably assert that the model developed in rational expectations theory is indeed the process economic agents go through when making their decisions. Furthermore, rational expectations theory has not sought to decipher how expectations are actually made in the minds of economic agents. This task has been filled in by recent developments in behavioral economics, where economists have begun to quietly dismantle the more psychological tenants of rational expectatio ns theory. 67 (See: Dan Ariely, Predictably Irrational.) The efficient market hypothesis is strongly analogous to the rational expectations hypothesis. Starting from the assumption that free economic agents are rational and will always make decisions in an attempt to maximize their own utility, and thus the overall utility of society (through the invisible hand mechanism), opponents of government regulation of markets developed a stronger corollary. If economic agents are rational then their aggregate, that is markets, are also rational. If financial markets are rational, then 67 Dan Ariely, Predictably Irrational: The Hidden Forces That Shape Our Decisions (New York: Harper Perennial, 2010) 3.
56 they will always come back to an equilibrium and thus there is no real need for any sort of serious intervention. Proponents argue for three forms of this hypothesis: weak, semi strong and strong. The weak form of the efficient market hypothesis does not hold that markets will return to an equilibrium but instead that market actors will not be able to consistently earn above normal profits from market inefficiencies. In this form of th e EMH, the information about future prices is only contained outside of the data for previous years. Thus, agents cannot predict, and in this way beat, the movements of prices within financial markets by analyzing previous movements. Accordingly, proponent s of the weak form of the efficient market hypothesis claim that the prices of financial markets must follow a random walk. The semi strong of the efficient market hypothesis holds that decisions are based upon publicly available information about shares All agents swallow this information up and adjust accordingly. Since this information is released publicly and is then assimilated instantaneously by all agents in the market, it is impossible to acquire an undue advantage and earn supernormal profits in the long run. Again, this is because all agents share the same set of information with no "insider" information. The strong form of the efficient market hypothesis holds that share prices reflect all available information and it is simply impossible for anybody to earn supernormal profits. While the rational expectations hypothesis leaves room for error within predictions, the efficient market hypothesis does not allow room for the possibility that
57 firms will indeed be able to acquire inside information by acquiring increasingly larger portions of the market and utilizing that influence in an extra economic capacity, and by political means come into information and arrangements which allow it to earn supernormal profits on a fairly consistent basis. Beca use of this, it does not seem that the efficient market hypothesis is sufficiently strong theoretically to support the claim that markets are efficient. Finally, it might prove fruitful to discuss the free market advocates' hesitancy, or even staunch op position to any form of fiscal (government) spending in response to periods of economic recession. Towards this end, the theoretical contributions of Milton Friedman should be briefly discussed as they pertain to this issue. Milton Friedman, of course, was probably the most famous academic advocate of the free market both in the United States and abroad. Milton Friedman was one of the founding fathers of the Monetarist school. In his first major contribution to the economic discipline in 1956, Friedman firs t sketched the Expectations Augmented Phillips Curve. The curve follows:
58 According to Friedman and all of those who have followed in his footsteps as his successors, the relationship illustrated by the short run Phillips Curve demonstrates that the inve rse relationship between inflation and unemployment exists only in the short term. Thus, policy makers can only hope to influence unemployment in the short term. In the long term, on the other hand, the curve is perfectly inflation inelastic. Where the ver tical curve fell on the x axis is where the natural rate of unemployment is found. This concept of a natural rate of unemployment is the reason that, due to frictional and structural unemployment, there is no way to wholly eradicate or even alter unemploym ent in the long term. Generally speaking, monetarists had little faith in fiscal policy, for they believed that all policy was essentially monetary policy. For the monetarists, the only way to combat unemployment was to make the labor market more flexibl e. This is a nice way of saying that in hard economic times, people should accept lower wages for the opportunity to work, so that way businesses could afford to hire more workers at a lower wage rate. Managing Risk In order to measure the way investors would behave, economists also developed models that could model how individual investors manage risk. The most popular of these models was created in the early nineteen sixties: the Capital Asset Pricing Model (or CAPM). The CAPM integrates all the assumpt ions that have been discussed in this
59 chapter. No investor has more knowledge of the assets in the market, all players are risk averse price takers, and all investors behave in the same way since they are pursuing the same optimum portfolio. Furthermore, t he model stipulates that risk is evenly distributed in the marketplace and that all investor poses the same expectations, given that all information is available to all. The actual function which traces the aggregate market line follows, although I will fo cus on the impact of the model instead of delving into the details of its functioning: E(r p ) = r f + [(E(r m ) r f )/ m ] p 68 Critics of the CAPM have argued that the model's assumptions are overly simplistic, and that more variables ought to be added to the equation in order to produce a more comprehensive picture. 69 Indeed, if the model that became the standard tool for predicting the behavior of the market as a whole was founded on incorrect assumptions about investor behavior, the situation was a precarious one. Filled with confidence that the behavior of markets could be mapped out, economists and executives became mor e comfortable with the idea of taking on additional risk in exchange for more profits. Another crucial model for measuring risk is the Value at Risk (VaR). The VaR was developed by quants working for JPMorgan during the 1990s. The model essentially measu res the "risk of a portfolio as the maximum amount of loss the portfolio can sustain given some predetermined confidence level." 70 The VaR model was certainly understood to be very useful to risk managers working for the banks and for the government. The 68 Nikiforos T. Laop odis, Understanding Investments: Theories and Strategies (London: Routledge, 2013), 232. 69 Ibid, 240. 70 Ibid, 245.
60 cr iticisms of the VaR, however, center around the notion that the model provides a false sense of security by assuring managers that they can predict the probability of a rare, negative event taking place. The risks that the VaR was designed to measure was t he risk of a single portfolio losing value because a bad day on the stock market. The risk that the VaR was not designed to measure, however, was the risk of a systemic financial meltdown. To paraphrase Nassim Taleb, this model gave risk engineers the impr ession that they could fly a plain without having to account for the possibility of a storm. In the years before the crisis, investment bank directors became confident that they could not only play the market well, but that all risk could be safely manage d. It is now clear that they were wrong. But how is it possible that such advanced models could have been so wide of the mark? I believe the answer can be found in a helpful distinction advanced by John Maynard Keynes and Frank Knight between risk and unce rtainty : Frequencies and probabilities can be calculated for risk. Uncertainty, on the other hand, means that there are no scientific basis for any probability estimates. 71 The problem in the years leading up to the recent crisis is that bankers were measu ring for risk, when they were in fact facing fundamental uncertainty. Owing to the size of the investment industry, the mismanagement of its assets, and the toxicity of these assets, it became impossible to responsible perceive, let alone manage, the risks inherent in market activity. Due to twin curses of collusion and shadow banking, the lenses of both the bank managers and investors became increasingly blurry, to the point where the models they were using to gauge risk could no longer served their design ated purpose. Unfortunately 71 David Luttrell, Harvey Rosenblum, and Jackson Thies, Understanding the Risks Inherent in Shadow Banking, (Dallas: Dallas Fed, 2012), 21.
61 for the world economy, managers would not come to realize that their models' predictions were inaccurate until it was much too late. The Principles of Self Regulation So what is it, concretely, about rational expectations th at dilutes any worries that the market might require outside regulation? The preceding sections demonstrate the importance of the conviction that economic agents, being human beings, are rational. Following from the assumption that people are rational, sc holars began to argue that markets are rational. This notion became increasingly accepted within the economics profession as several key figures at the University of Chicago conducted several empirical studies to demonstrate that relationship. 72 The first steps toward a belief in market self regulation were much shyer than the doctrinal character it would later acquire. The road toward the "Efficient Market Hypothesis," as the belief in rational, self regulating markets would come to be known, began with a simple defense of the stability of financial markets. In response to the notion that financial markets were unstable sectors within economies, Milton Friedman turned the accusation on its head. To argue that speculation was de stabilizing, said Friedman, would be identical to claiming that speculators on 72 Justin Fox, The Myth of the Rational Market (New York: Harper, 2009), 107.
62 financial markets lose money. 73 To argue that markets are destabilizing would be to say that financial agents typically sell when the currency is low and purchase more of it when its price is high. This wo uld indeed be a source of instability. But to sell low and purchase high is the behavior totally opposed to what one would and should expect of financial speculators. Speculators speculate in order to make money by purchasing low and selling high and as th e record shows, they typically pull this off fairly well. This last assertion was cemented by the statistical "random walk" which formally mathematized the thoroughly unpredictable behavior of the stock market, a model which attracted a great deal of atten tion in the nineteen sixties. And if speculators typically make money via their speculation, then the idea that financial speculation is destabilizing carries little merit. The economist Gene Fama provided the specific conditions for theorizing the effici ent marketplace by arguing that in whatever case in which a non random pattern or streak occurs within the market -providing higher than usual returns -traders would immediately attempt to get in on it to extract additional profits and thereby extingui sh those opportunities. 74 The existence of these occasions was not an oddity. In fact, it happens within markets often. But the innovativeness of Fama's position was that it described in straightforward terms why economists and firms could count on markets to self adjust. In other words, Fama posited that markets are efficient. Fama wrote that in an efficient market, "the actions of the many competing participants should cause the actual 73 Ibid, 92. 74 Ibid, 97.
63 price of a security to wander randomly about its intrinsic value." 75 It is right away clear that Fama is here invoking the random walk models of price movements. What is less clear, though, is the distinction between the actual price and the intrinsic value of a security. Such intrinsic values of stocks are "supposed to reflec t fundamentals of their companies, such as capital equipment, inventories, unfilled orders, profits..." 76 In basic economic nomenclature, this is the market capitalization. The problem with the notion that prices rotate around the some inherent set of quali ties of a stock's company is that as any daily ticker will show, stock prices are actually much more volatile than the components "inherent" in them. It makes little sense then, to say that these prices which fluctuate faster than the intrinsic value conse rves a definite relationship to those intrinsic values. 77 Economic definitions of efficiency in regards to market differ within a spectrum. The meekest form of efficiency being "weak," the next being "semi strong" and the most efficiency being "strong" eff iciency. 78 The first sort of efficiency is defined as the hypothesis that any one speculator could beat the market average using historical data of price movements. The middle term is understood as the hypothesis that speculators could not beat the market a verage return with publicly available information. Finally, a strong efficiency would mean that speculators could not beat the market even if they had insider knowledge before publication. By the mid nineteen sixties, the economics and financial contingent s at the University of Chicago felt that the fact that markets have weak 75 Ibid, 97. 76 Ibid, 193. 77 Ibid, 193. 78 Ibid, 101.
64 efficiency had been well enough established by empirical research. With increasing confidence, they began to push the envelope and argue for strong efficiency. To this end, they condu cted research in 1967, whereby they found that "85 to 90 percent of the news in annual corporate earnings reports had already found its way into prices...before the reports were released." 79 This led Michael Jensen to write of the strong efficiency hypothes is: One must realize that these analysts are extremely well endowed. Moreover, they operate in the securities markets every day and have wide ranging contacts...the fact that they are apprentice unable to forecast returns accurately enough to recover thei r research and transactions costs is a striking piece of evidence in favor of the strong form of the hypothesis. 80 Within a few years, the idea that markets were efficient, even in the strongest sense of the terms, was widely accepted as true. But how is this connected to government regulation? For this connection, one must turn to the founding father of American free market advocacy, Frederich Hayek. Hayek's original nineteen forty five argument against government regulation of markets was that government officials and bureaucrats simply lacked the knowledge to perform well in such a capacity. Markets being as complicated as they are, there is no conceivable way for a government official to know how enough about the operations of the actors in question to be able to regulate them. As some contemporary commentators will joke, anyone clever enough to know the markets well enough to regulate them would go to work for one of the firms. 81 Moreover, the understanding of what makes the markets tick "never exists in concentrated or integrated 79 Ibid, 102. 80 Ibid, 103. 81 Inside Job. DVD. Directed by Charles Ferguson. New York: Sony Pictures Class ics, 2010.
65 form, but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess." 82 This early argument would only be confirmed in the eyes of the Chicago school by means of their research into market efficiency two decades later. Easily enough, this led economists such as Milton Friedman to assert that "markets work better than government." 83 In an elegant system of hypothesis and philosophically supported convictions, the l aissez faire economic strand of thought preached of market self regulation and prescribed government non intervention. Once neoliberal converts took advantage of the lobbying mechanism present in American politics the arcane formalizations of economists, t heorists, and financiers would seep into the mainstream of policy making by way of a moratorium on government regulation of the American financial sector. 82 Fox, The Myth of the Rational Market 91. 83 Ibid, 94.
66 Chapter 3: Chicago on the Rise or; Neoliberalism in the Popular Press So far this thesis has developed the structure of laissez faire ideology. And this set of ideologies is indeed a powerful driving force behind all sorts of activity in business and policy making. What brings free market ideology more to life, however, is its historical poli tical aspect. The course and personalities in the United States' neoliberal movement, over the last several decades, offers rich insights into the largest financial crisis this country has suffered since the Great Depression. The period following the Gre at Depression can be widely characterized as a period during which the pro laissez faire movement's efforts were conducted from boardrooms and corporate offices. Once free market ideology examined in the second chapter began to gain traction inside the Ame rican academy, free market proponents took to the public avenues of influence. Thus, this chapter also considers the intersection of free market advocacy (now in the guise of neoliberalism) with the lobbying culture of the United States in the more recent decades. Historical: Economics Goes Pop For the elite of the American business class the Great Depression was not just an
67 economic crisis, but just as much of a political crisis. 84 Following a wave of repression taking place after the close of the Great War, union membership had been swiftly curtailed from 19.4% to 10.2% of the workforce in just ten years. 85 The time period since the arrival of piece had seen America's business community finally overcome the tainted image of Gilded Age robber barons. Durin g the 1920s, businessmen were seen as leaders of the community: adventurous and glamorous. In short, the 1920s were a time of easy riches and capitalist ideological hegemony. After almost three decades of contentious public struggles between the businesses and the unions, America had come to venerate business. 86 In the words of President Calvin Coolidge, "the chief business of the American people is business. With the arrival of the Great Depression's initial stock market crash, the American business elite registered a change in the atmosphere, although the exact nature of the change remained unclear. Myron Taylor, president of U.S. Steel wrote: "Out of the depression we have been going through, we shall have learned something of high importance, but it is too soon to say just what we are learning." 87 Indeed, the response from other notable business leaders did not share Taylor's concern. In fact, some even sought to deny the severity of the Depression. One contractor wrote President Hoover saying that "there is not five percent of the poverty, distress and general unemployment that many of your enemies would have us believe." 88 President Hoover stuck close to 84 Phillips Fein, Invisible Hands: The Businessmen's Crusade Against the New Deal (New York: W. W. Norton & Company, 2010 ), 6. 85 Ibid. 86 Ibid. 87 Ibid. 88 Ibid, 7.
68 these elites, calling them in for meetings in which he attempted to repair the economy from the produc er's side, by maintaining wages steady and prolonging the firing of large numbers of employees. All throughout, President Hoover maintained an optimistic attitude about the crisis. After three years of "glib reassurances," business elites began to realize that Mister Hoover just would not do. For these high level businessmen, politics was the ground for investment. The return on these investment would of course be favorable policies. By the time of the 1932 election, a great new opportunity presented itself His name was Franklin Delano Roosevelt, which meant that he was the heir of one of the wealthiest and most prestigious families in American history. Educated at Harvard College and Columbia Law School, Roosevelt struck the business community as someone who had their interests in mind. Unlike Hoover, he promised to be a better steward of the economy in a time of serious crisis. And this was a view that Roosevelt himself welcomed. Roosevelt reached out, courting business leaders to rally around his "New D eal" agenda. 89 Many of them were convinced that the Keynesian economic plan would raise wages and employment and be able to stimulate demand and thus increase their sales. As many of them would come to regret, the Roosevelt campaign was helped to victory by their financial support. As the policies of the New Deal began to have their effects, many in the business community had a sudden change of heart in regards to their support of Roosevelt. In combination with the popular strikes and protests across the na tion, officials inWashington began to take positions which expressed loud and clear that their faith in 89 Ibid.
69 free markets had been permanently shaken by the 1929 crash. And by granting the right to unionize to many workers and setting a national minimum wage, t he policies of the New Deal came to be seen as a threat to the free market capitalism they were conceived to protect. 90 The "employer's paradise" had been lost. In response to this, several high profile politicians and businessmen took part in a series of meetings in July of nineteen thirty four brought together in order to form a union of employers, after the fictional account of Ayn Rand's Atlas Shrugged The Liberty League, as it came to be styled, was created to defend the constitution and the rights of "property holders" by disseminating information about industry and finance as well as organize the business community in defense of its own interests. In a clever marketing play, the organization decided to omit any reference to the defense of property in their name opting instead to adopt vague classical liberal posturing. The organization presented itself euphemistically by speaking non partisanship and of "combating radicalism, [preserving] property rights, uphold and preserve the Constitution." 91 Soon e nough, however, the gloves came off. In their line of pamphlets, the Liberty League publicized the "ravenous madness" of the New Deal, it's usurpation of power. 92 On perhaps a more personal note, the league protested the fact that "businessmen are denounced officially as 'organized greed'...the dragon teeth of class warfare are being down with a vengeance." 93 This was to be the start of a decades long reaction to the New Deal, which was to come to shape the American conservative movement and have far 90 Ibid, 9. 91 Ibid, 10. 92 Ibid, 11. 93 Ibid.
70 reaching economic consequence. The 1950s recorded a significant alteration to economics research in the United States. As mathematical economic models became all the rage, economics departments drifted away from political and theoretical questions and instead foc used on developing or perfecting statistical models and methods of creating projection. Against this current, economists like Hayek and von Mises continued to stress the moral aspects of economic theory, centering their work on issues such as freedom and t he relationship between the state and the individual. 94 The space between these more polemical authors and their mathematized counterparts was filled in by business schools and businessmen, as has been discussed above. Braiding these threads of theoretical development and politically engaged businessmen together, groups like the Mont Pelerin Society and the Foundation for Economic Education (FEE) which consisted of a mixed batch of professional economists and businessmen interested in advancing the cause for classical liberalism and reversing the tide of New Deal policies. Incensed by the perceived leftist threat of the 1950s, businessmen like W. C. Mullendore and Lemuel Ricketts Boulware used company newsletters to send out political messages. One of them sa id that "our free enterprise system has been replaced by a Government guided economy (the welfare state), and all free enterprise is basically weakened and endangered." 95 These business leaders mobilized their own enterprises to spread awareness of the meri ts of the free market system and how it was inextricable from the 'American Way.' One of Kim Phillips Fein's commendable achievements in her book Invisible 94 Ibid, 52. 95 Ibid, 54.
71 Hands is to correctly trace a cleavage on the face of the twentieth century capitalist revival. Eve n within the neoliberal movement, there were salient differences of opinion which styled the flow of the movement into popular consciousness. One of the most important was the disjunction introduced by Ayn Rand. Rand was an important champion of unfettered capitalism and was unabashed in here moralizing discussion of economic policy. But for Rand, there was a crucial mistake to be avoided. Though the advocates of free markets were correct in their affirmations of capitalism as the system best fitting a free society, they were incorrect anytime that they framed it as such by appealing to some notion of either 'the common good' or religion. To do so would be a terrible mistake, inviting contradictory notions of collectivism or irrationality correspondingly. 96 O n this issue traditional neoliberalism and Rand's Objectivism are absolutely irreconcilable. This author will remain focused on the larger movement rather than digress onto Rand's extensive commentary on issues pertinent to economic philosophy. Rand's chal lenge did not go ignored, however, and did force the hand of many businessmen who admired Rand's fearless championing of laissez faire capitalism but sought to reconcile it with some sort of religious devotion or notion of collective development. This div ide serves as a good guide to understand what happened next. In the 1940s and 1960s, businessmen like J. Howard Pew sought to enlist American Protestantism in the fight against communism and social democracy. This result was "Spiritual Mobilization," a gro up which utilized funding made available by businessmen to purchase laissez faire literature, such as Hayek's The Road to Serfdom and distributed 96 Ibid, 69.
72 it to the country's clergymen. 97 By way of this educational campaign, men like Pew sought to cut off the aberra nt strains of liberal theology which he thought legitimated social democracy as an enactment of Christian principles of altruism. Collective salvation was to be achieved through capitalism alone. In the words of James Fifield, "The blessings of capitalism come from God." 98 The second notable response to the break introduced by Rand was that of William F. Buckley. Upon first meeting the man who would late become of the most popular conservative pundits in American history, Ayn Rand commented that he was "too intelligent to believe in God." 99 Buckley retorted by publishing several sharp critiques of the Hollywood writer. Buckley's contribution was firstly, to emphasize the moral texture of conservative thought by focusing on ideals rather than "mere materialism ," and secondly to begin publication of his National Review magazine. 100 Funded extensively by Buckley's Yale friend Roger Milliken, the magazine sought to revive interest in conservative discourse in those quarters of society where it was perceived as "mori bund." Specifically, it eschewed any anti intellectual tone and aimed at a readership of the nation's movers and shakers, as well as young college students. Buckley's National Review popularized critiques of the media it perceived to be liberally biased an d emphasized American conservatism, and its support of a "competitive price system" as "both plausible and profound, politically realistic and morally imperative." 101 The public relations campaign of the American businessman took new importance 97 Ibid, 73. 98 Ibid, 72. 99 Ibid, 77. 100 Ibid, 79. 101 Ibid, 78 79.
73 in the later 1960s. In the face of widespread discontent and a special targeting of big business as the progenitor of a War to defend capitalism against the communism it so despised, various business leaders came to the conclusion that a new campaign was needed to mak e a case for the importance of the business sector and the capitalist way of life. Amidst this climate, prominent lawyer Lewis Powell authored what would later come to be known as the "the Powell Memorandum." This memo "crystalized" the concerns of the Ame rican business community in the late 1960s and the early 1970s. In the memo, Powell argued for a coordinated campaign to assert the importance of the "American free enterprise system." 102 Some of the most influential conservative and neoliberal personalities of later decades would cite the Powell Memorandum as an inspiration to political involvement. Lobbying once Popular The first chapter of this thesis investigates the background and causes of the 2008 Subprime crisis and the way in which that financial crisis rapidly spread to the rest of the economy, first in the United States and in the rest of the world soon after that. This chapter's first section provides a historical perspective of neoliberal theory and influence. But the more important aspect of this movement to re popularize the bare essentials of capitalism for this thesis is the role that finance played in free market advocacy in the last four decades and how that advocacy ultimately entrusted the present generation with an extremely influentia l financial sector. So how exactly did the financial 102 Ibid, 162.
74 services industry become disproportionally influential? It is no secret, and it has been demonstrated in this thesis, that the regulators in Washington were uncommonly friendly to the financial sector. Wall Street firms were and are to this day some of the biggest campaign contributors to the political campaigns of congress men and congress women. To be precise, the financial industry firms spent $1.7 billion on campaign contributions in the ten years betw een 1998 and 2008. 103 There is some debate, however, where the courtesy started. That is, do politicians endorse policies that are friendly to their donors, or do donors merely endorse politicians that are friendly to their interests? In either case, there i s an usual line of thought which touts the opportunity to contribute to political campaigns as an indispensable and just aspect of representative democracy. Regardless of how one wishes to approach that discussion, the case is that there was a coincidence between increased financial sector contributions and financial deregulation in the 1990s. 104 During this time, financial industry donors focused their efforts on the Congress members who were most readily able to help them. This meant that people like Phil Gramm and later Christopher Dodd, chair of the Senate Banking Committee and Barney Frank, chair of the House Financial Services Committee, received the most money in the form of contributions out of all Congress members, excluding those with presidential races. 105 The biggest recipient of financial sector contributions was Christopher Dodd who received 2.9 million dollars in one single year (2007 2008) as 103 Simon Johnson and James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (New York: Vintag e, 2011), 91. 104 Ibid, 91. 105 Ibid, 91.
75 head of the Senate Banking Committee. Not surprisingly, Dodd's predecessor Phil Gramm was the primary sp onsor of crucial pieces of legislation such as the Commodity Futures Modernization Act of 2000 and the Gramm Leach Bliley act. The former prohibited Federal Regulation of financial derivatives and the latter effectively repealed the Glass Steagal Act. In t he words of Senator Richard Durbin, the investment banks are "the most powerful lobby on Capitol Hill. And they frankly own the place." 106 If the question of Wall Street's influence over the US government was merely a question of campaign contributions, how ever, the problem wouldn't be too bad. This is because much of the policy that concerns Wall Street is actually determined by officials who are appointed, not elected. This would seem to put an end to any worry of corrupt meddling in what would otherwise h ave been more stringent regulatory policy. But this is where the real problem lies. Wall Street banks refined their ability to obtain important appointments to key Washington posts. This was achieved in two main ways. On the money side of things, Wall Str eet affiliated individuals had an increasing potential as political fundraisers due to their connections the richer the Wall Street banks got. This meant that for politicians or administrations who needed to raise money efficiently, selecting a former Wall Street banker was just about the safest bet that could be made. But there is a more subtle motive for Wall Street's ability to work its way into influential appointed positions: their familiarity with complexity. As the tools created and utilized by the f inancial sector increased in their mathematical complexity, fewer and fewer people were sufficiently familiar with them to understand how they worked. Additionally, the financial sector was 106 Ibid, 92.
76 becoming more and more important within the US economy. Taken toge ther, these two facts translated to a higher bounty on any individual who could give politicians insight into the financial sector because that knowledge was increasingly important and also increasingly rare. Ultimately, this meant that those who received appointments to oversee the financial industry often sought the opinions of the most important members of that industry, since they themselves lacked enough insight. This created was has been termed the "Wall Street Washington Corridor," made up of offici als and executives flying back and forth between the cities in relation to the industry's oversight. In his 1971 paper "The Theory of Economic Regulation," George Stigler described the process by which regulatory bodies were "captured" by the sectors they were meant to regulate. Stigler argued that generally speaking, regulation undergoes this capture by the industry and is designed "primarily for its benefit." 107 Stigler furthermore argued that this capture is not at its best a result of corruption but rath er when the perceived interests of the regulators and the regulated aligned. Now, prima facie one would assume that this refers to personal financial interests. And it is undeniably true that Washington regulators who served the interests of the financial industry were amply rewarded with cushy positions once their term was up. 108 But the sort of interests that require additional emphasis are the perceived general interests of the nation. This is where the focus of previous investigations is somewhat lacking, for the passing of legislation that was beneficial to the financial services industry cannot be explained 107 Ibid, 93. 108 Ibid, 92.
77 adequately by citing conflicted personal interests between the regulators and those sectors that they oversaw. Instead, one should come to understand that regulators actually and genuinely came to believe that what was good for the financial industry was indeed what was best for the nation's development as a whole. This was a question of good faith on the part of regulators, and the fact that they shar ed in the ideology, which has been detailed earlier in this thesis. And as the financial industry itself became riskier and more aggressive, so then did the people who acted as consultants to the industry's regulators. Soon enough, on the more pressing qu estions of the day, all the people with any considerable experience were veterans of Wall Street. In order to remain both aware and informed of what was happing in this important sector of the economy, government regulators were forced to rely on current a nd former Wall Street executives. 109 This reliance on Wall Street know how combined with tight personal and professional relationships between government officials and Wall Street executives resulted in Wall Street obtaining an privileged informal advisory p osition not just on financial industry affairs, but on wider matters economic as well. To top it all off, the same free market ideology which had been advanced by activist members of the academic and business sectors predictably bled into the halls of gove rnment, which in conjunction to a free market Federal Reserve, resulted in the prevalence of vast deregulatory measures that took place in the 1980s and 1990s. Indeed, by the late 1990s, a combination of large money, similar personalities and growing pres tige in the Wall Street Washington Corridor created what Jagdish Bhagwati 109 Ibid, 94.
78 calls the "Wall Street Treasury Complex." 110 As Bhagwati can attest, free market ideology "lulled many economists and policymakers into complacency" about the dangers of riskier and ri skier financial practices. The pitfalls, wrote Bhagwati, that "certain markets inherently pose." 111 Guided by this deeply intrenched ideology, both businessmen and politicians found themselves unable to distinguish between the good of the financial sector, a nd its latest unstable risk means rich practices, and the good of the US economy and wider global financial sector as a whole. Following three decades of financial deregulation and decreased government intervention in key sectors of the economy, the 2007 f inancial crisis struck a set of institutions which were wholly unwilling and unprepared to deal with its destructive aftermath. 110 Ibid, 118. 111 Ibid, 118.
79 Chapter 4 : "Skin in the Game" Details of Free Market Ideology So far throughout this thesis, I have employed the term 'ideology' as a relatively non technical term. In a general sense, an ideology denotes a set of beliefs, doctrines, or myths, often justificatory, about given social or political conditions which in turn guide individuals and groups in their behavior. 112 But in order to reach more meaningful conclusions about the 2008 financial crisis and the de regulatory doctrines which have come to bear the blame for it, it is helpful to refine our notion of ideology. Within the European political philosophy traditi on, the term "ideology" has in fact been raised to a highly technical term. As any other highly contested technical term, disagreements abound about what ideology really is, what it does, and how it does it. Anthropologist James C. Scott best captures the range of meanings for ideology when he describes ideology as the set of beliefs which normalize structures of domination. 113 In other words: What are the ideas which allow subjugated peoples to quiesce to a marginalizing group? The inherent assumption here i s that subjugated peoples must, in order to remain in an involuntary subjugated position, adopt some sort of "false consciousness" which inhibits active resistance. In his fulminating critique of the study of ideology, James C. Scott makes a useful distinc tion between "thick" and "thin" theories 112 http://dictionary.reference.com/browse/ideology 113 James C. Scott, Domination and the Arts of Resistance, (New Haven: Yale University Press, 19 90) 70.
80 of ideology. According to the "thick" theories of ideology, societies utilize "ideological state apparatuses" as instruments of producing social cohesion. These instruments of social normalization include churches, schools, the media, etc. These are the institutions which serve to manufacture consent on the part of the subjugated for the conditions which produce their subjugation. The "thin" theories of ideology, on the other hand, are a lot more modest and therefore much more compelling and difficult to refute. These perspectives have elites defining for subordinate groups "what is realistic and what is not realistic and to drive certain aspirations and grievances into the realm of the impossible, of idle dreams." 114 T hus, it is not so much that the dominant social groups actively suppress the rebellious spirit of disempowered groups, but that any effort at changing the state of affairs is dismissed as unrealistic. Most often, this understanding is a side effect of the portrayal of the state of affairs as normal. Thin theories of ideology describe elites as promulgating the impression that the contingent social arrangement is not contingent, but in fact unavoidable. For instance, capitalist theorists have consistently in sisted that the free enterprise system, supported by private property and private interests, is a result of human nature's inherent egotism and the gap between needs and desires. From the opposing view, Marxist theories cast the capitalist arrangement of p roduction resources as an affront to human nature's inherent productivity and cast the communism arrangement as the natural outcome of a just equivalence between efforts exerted and rewards reaped. 115 Another crucial distinction introduced by James C. Scott is the distinction 114 Ibid, 74. 115 As an interesting side note, both traditions have tended to pin their version of human nature upon enlightened principles of rational self governance and enlightened self interest.
81 between the public and private transcripts. The distinction boils down to recognizing that it is difficult to ascertain what subjugated peoples actually believed at any given point, since the subversive opinions of marginalized groups a re, by definition, excluded from the public transcript. So although serfs, peasants, and untouchables may appear to consent to, or at the very least quiesce to the conditions of their oppression, they in fact probably do not. 116 Instead, subjugated groups cr eated a series of private transcripts away from the leering eyes of powerful censors, government officials, and captains of industry. The difficulty is that, by virtue of their very definition, private transcripts never made it into the public discourse. I t is difficult for historians to accurately assess the extent to which publicly endorsed ideologies were incorporated by those who were hurt by those ideologies. One of the most compelling "thin" theories of ideology is the one proposed by Slovenian philo sopher Slavoj i # ek. i # ek argues that the "ultimate ideological operation" involves "the very elevation of something into impossibility as a means of postponing or avoiding encountering it." 117 This should sound somewhat familiar, given our preceding discus sion of James C. Scott's analysis of the ideology critique literature. i # ek does not intend to argue that impossibilities are not encountered, but that they are traumatic. For example, i # ek argues that romantic courtship can be seen as a strategy for the avoidance of the physical consummation of love. Thus, i # ek's logic, informed by his psychoanalytic training, is that societies avoid the true encounter with the "object" of their public transcript. In more concrete terms, when we analyzed the discourse o f 116 Scott, Domination and the Arts of Resistance 80. 117 Slavoj i#ek and Glyn Daly, Conversations with Slavoj !i"ek (Cambridge, UK: Polity Press, 2004), 70.
82 neoliberal theory, there was a marked tendency to approach economic policies in moral terms. Specifically, the popular press side of neoliberal theory strongly emphasized the ideals of freedom and liberal democracy. In fact, the argument is made at vario us times, and in various different guises, that free market capitalism both respects individual freedom and furthermore serves as a vehicle toward greater democratic development and the realization of the promise of political liberalism. What can be obser ved throughout much of the most popular versions of neoliberal theory is the idea of a teleology. Teleology refers to an instance in which a process is undertaken towards a final cause. Again, when discussing the literature that popularized free market cap italism, one observes the implicit argument that to a certain extent, the merit of capitalism is that free markets promote freedom and democracy. This argument is actually made explicitly by Friedman, Hayek, and Rand, but exists implicitly in much of the l ess popular literature. And here comes the punch line : By deploying i # ek's theory of ideology apropos neoliberal economic theory, important new insights stand to be gained. What i # ek describes in his thin theory of ideology may effectively be understood as the suspension of a teleology that dominates the public transcript. In this case, I want to argue that the truth of neoliberal ideology is neoliberal policy's suspension of neoliberal theory's teleological working toward the realization of the liberal values of freedom and democracy. Neoliberal ideology functions by obfuscating two key facts. First: de regulation is an offense against democracy. Second: Economic activity is not made up of sterile interactions, but is always ultimately a contestation of limited resources by different
83 social factions. By obfuscating these key facts, neoliberal ideology served to retard the very ideals it purported to advance. It is necessary to make an important conceptual distinction, however, between neoliberal and neo classical economic theory. For while strictly laissez faire economic theory is teleological, as this thesis asserts, neoclassical theory is not. In contrast to laissez faire economic theory, neoclassical theory is a much more mechanistic body of theory. Ne oclassical economists do not design their models in order to advance freedom, or democracy, or anything of the sort. Instead, neoclassical economics focuses strictly on the analysis of efficiency in the marketplace. Thus, there is nothing teleological abou t neoclassical theory. The problem is that free market advocates became quite good, as has been discussed, at masking economic arguments as moral ones. In their lobbying efforts, free market advocates advocated the elements of neoclassical theory that best fit their vision while appealing to policymakers' moral compass. This obfuscated the true mechanistic nature of neoclassical theory, and compounded the widespread misunderstanding of neoclassical economic theory on the part of decision makers in Washingto n, D.C. and New York. As we have observed repeatedly, freedom and democracy were the values most cherished by the advocates of neoliberal reforms. Undoubtedly marked by the recent experience of Fascism in Europe and the subsequent humanitarian and economi c disaster that gripped Europe, the advocates of the neoliberal school sought a return to limited government, respect for individual liberty, and popular participation through market mechanisms. The trouble is that the policy prescriptions advocated by the neoliberals was
84 that they dismantled the most powerful method of popular participation in the economy at large: legislative regulation. The legislature, as the representative voice of the people, exists as a mechanism to extend the democratic grip of the citizenry into areas traditionally outside of their direct or indirect control. While representatives may be recalled, corporations are not directly accountable to the people. In fact, corporations were invented as a method for avoiding personal liability and risk so that the owners could conduct their business more freely. Consequently, the public has no way of strongly dissuading corporations from engaging in practices it sees as unfit. A popular defense advanced by free market advocates was that citizens could very simply vote with their dollars. 118 But while they advocated democracy through the market place, free market advocates utilized their influence in the halls of government to hamper the most direct instrument of intervention the public had in matte rs of business. Accordingly, free market advocates' public transcript, their official position, favored personal liberty and democratic participation, while their policy prescriptions impaired those very things, by arguing that such public intervention was fundamentally incompatible with liberty and democracy. In this feat of ideological gymnastics, free market advocates denied in practice the very teleological movements that they advocated in theory. Moreover, an even stronger Marxist claim could be made here: all the while praising the values of democracy and individual liberty in the guise of property, free 118 This quintessentially American notion presents an interesting challenge which unless probed, does not yield its secrets. This logic functions as follo ws: through the capitalist system's reliance on monetary activity makes it especially vulnerable to consumerist activism. In situations of oppression, disagreement, or disenchantment, consumers may discipline a corporation, or perhaps an entire industry, s imply by refusing to purchase from it. In other words, just as citizens participate through their vote, consumers in the democracy of the marketplace vote with their dollar.
85 market advocates are most vehemently opposed to worker's control of their labor. In a slightly milder claim, one could say that even the right of lab or to organize is undermined by free market advocates' insistence on the necessity of labor markets to "flexible." In either variety, a Marxist reading further radicalizes the extent to which the neoliberal ideology obfuscates its internal contradictions. Finally, a much more general obfuscation may now be brought into relief. When taking a closer look at the role of democracy in economic policy one key fact is consistently overlooked: economics relates the contestation of limited resources (natural, human capital) by different social groups. Even a cursory reading of early political economy reveals an acute awareness of the competition between different social factions. From Ricardo's concern with the competition between landowners and merchants to Marx's concern with the competition between aristocrats, capitalists, and workers. In a word, political economy historically considered the fundamental antagonisms which organized the modalities of economic activity. Such a discussion, or even acknowledgement, is conspicuously absent from the pages of neoclassical theory. In the writings of free market advocates, the market serves as the ultimate historical conflict mediator. Given access to the market, all social antagonisms are dissipated with a wave of the Sm ithian invisible hand. Such sterile political economies seek to immunize themselves against the persistence of social antagonisms in the economic arena by appealing to market apparatuses as the tools of resolution and social intercourse. But such an immuni zation can never be successful. This second level of ideological operation obfuscates the fact that economic
86 resources require, from time to time, extra market administration, therefore adding impetus to the deregulation crusade. If economics does not des cribe the constant contestation of resources between different social groups with different positions and competing interests but rather the efficient distribution of shared resources amongst different agents in order to ensure the greatest benefit to the social body as a whole, it follows that there exists no incentive towards popular participation in the regulation of the marketplace. It is important to emphasize that this is not a neutral fact. For the dismantling of regulatory mechanisms places certain social groups at an advantage while relatively disempowering others. Should the inherent question of contestation of resources resurface in the annals of economic theory, the democratic imperative will regain its central importance. One does not need to a dopt a Marxist perspective, however, to be concerned. In fact, one may remain entirely within a capitalist framework and still raise the same objections. 119 This means arguing that the very foundational texts that neoliberal theory drew upon were misrepresen ted, or distorted, by neoliberal theory. For as any reading of Adam Smith will demonstrate, the promotion of contestation as competition is a key tenet of orthodox capitalist theory. Policy Proposals 119 In fact, Marxian economic theory parts tacit assumptions that are significantly different from those of classical and neoclassical economics, which makes Marxian critiques of free market theory liable to pack a lesser punch, given that shared starting assumptions are necessary perquisites to a constructive debate. For properly Marxian critiques of the financial crisis, see: Robert Brenner, The Economics of Global Turbulence (New York: Verso, 2006); David Harvey, The Enigma of Capital (Oxford: Oxford University Press, 2011).
87 Complexity magnifies the opportunities for obfuscatio n." 120 The important question is the following: What is to be done? Well, how can one remediate the aforementioned problems and return to democracy by emphasizing contestation? I believe the problem lies with the existence of financial institutions that are deemed "too big to fail" (TBTF). The TBTF institutions pose two specific sorts of problems to the health of the economy. Fist, the TBTF institutions effectively illegitimately extend the insurance offered by the government to failing financial institution s 121 Second, the TBTF institutions obstruct the road to recovery by hampering the "prompt corrective action" (PCA) efforts of the Fed. 122 The Federal government provides a safety net for the banking industry in the form of the Federal Deposit Insurance Corp oration (FDIC). The FDIC insures, as they name suggests, the FDIC is responsible for stepping in at the time of a commercial bank failure and securing deposits. By freezing the assets of failed banks and securing their takeover by healthy competitors, the FDIC acts, as the name implies, as a government guarantee that consumer deposits will not vanish with the failure of any particular bank. Crucially, investors with stakes in these banks are typically wiped out in cases of failure, and thus tend to impose d iscipline on the banks' management. Historically, the FDIC has been enormously successful. The problem in the past two decades has been that the FDIC has become de facto responsible for insuring assets that it should not be liable for. As financial insti tutions 120 Federal Reserve Bank of Dallas, Choosing t he Road to Prosperity (Dallas: Federal Reserve Bank of Dallas Annual Report, 2011), 7. 121 Ibid, 13. 122 Harvey Rosenblum, Jessica J. Renier and Richard Alm, Regulatory and Monetary Policies Meet Too Big to Fail (Dallas: Federal Reserve Bank of Dallas Econ omic Letter Vol 5 No 3, 2010), 4.
88 have become increasingly large and complex, budding the numerous subsidiaries which I have referred to as the "shadow banking industry". 123 In the cases of TBTF failures, the institutions are far too large, by definition, to be ignored. Although the FDIC is forced to react to the failure of the TBTF institutions' commercial banking branches, the federal government should have no obligation to step in to save the remaining distended constellation of subsidiaries. Yet, when the crisis happened, the fede ral government was forced to step in to prevent a larger catastrophe. In short, the existence of TBTF banks illegitimately extended the safety net provided by taxpayers to the financial industry. This encourages risk taking and limits the pressure that sha reholders and creditors will be willing or able to exert on the management, knowing they will be bailed out in case of failure. Prompt Corrective Action, or PCA, refers to the tools at the disposal of the federal government for ameliorating the economic d ownturns which inevitably occur in capitalist economies. The most familiar of which is the modification of interest rates on last resource loans from the Fed to banks. It is important to highlight that in regards to PCA, the Fed has an impressive track rec ord. 124 The TBTF institutions inhibit the carrying out of PCA because they inhibit the basic promptness of the PCA. In order to reduce losses to the FDIC and ensure that critically under capitalized banks do not threaten the stability of the system as a who le, the Fed must firstly identify underperforming institutions and then quickly deal with them 123 Harvey Rosenblum "Too Big to Fail" (February 7, 2013), YouTube, 36:20, http://www.youtube.com/watch?v=qjxi9jxDWBc (accessed March 25, 2013). 124 "Before the Federa l Reserve's founding in 1913, recession held the economy in its grip 48 percent of the time. In the nearly 100 years since the Fed's creation, the economy has been in recession about 21 percent of the time." Federal Reserve Bank of Dallas, Choosing the Roa d to Prosperity 4.
89 so that their toxicity does not infect other players in the system. As one might intuitively recognize, TBTF institutions hamper both these goals in drastic ways For one, TBTF are composed of a large winding series of parent companies, subsidiaries, and other elements, whose specific functioning is opaque and troublesome to oversee and regulate. This problem, which I identified earlier in this thesis under the te rm "shadow banking" has made it impossible, especially once personnel constraints are considered, for regulatory institutions to effectively identify how accurate the balance sheets for these investment banks are. Furthermore, since these banks deal in the same new and unregulated financial instruments, they rise and fall together. Things are jubilant when we are all rising with the banks, but it is part of human psychology to forget that such expansions are unsustainable. When the banks fail, as they inevi tably will, they fall together. In so doing, they overwhelm the safety net's capacity and make it impossible for monetary and fiscal policy to take prompt corrective action. This is not a problem of regulatory weakness, or oversight failures. These institu tions are simply too large, too central as financial nodes, to be isolated. And in the case of failure, they are too large and complex to be chopped up and sold, most especially when the competition is just as sick as the original patient. 125 From a purely capitalist perspective, the financial industry has displayed a disturbing trend from imperfect competition towards full blown oligopoly over the past 125 PCA is well intentioned, but it assumes that bank failures are isolated events, a notion that made sense before the banking system became so highly concentrated and interconnected. Even more problematic, PCA isn't equipped for the cha llenges of too big to fail financial institutions. When a lot of banks are in trouble at once, or when one or more TBTF institutions are tottering, efforts to keep the financial system sound are delayed with potentially serious implications for monetary po licy. Rosenblum, Renier and Alm, Regulatory and Monetary Policies Meet Too Big to Fail 6.
90 few decades. In 1970, the top 5 banks in the industry controlled 17% of the industries total assets. In 20 10, after decades of de regulation, they controlled 52%. 126 De regulation did not lead to an efficient and competitive marketplace. It led to the consolidation of the financial industry by bloated, unmanageable banks. In this transition, all the benefits of free competition were surrendered in exchange for the illusion of consistent extra normal profits. For all of the excitement that the Dodd Frank Act has gotten, it actually perpetuates the entrenchment of the TBTF category of banks. It is true that Dodd F rank lays the groundwork for several new supervisory agencies, but as Harvey Rosenblum writes, "he overall strategy for dealing with problems in the financial industry involves counting on regulators to reduce and manage the risk. But huge institutions sti ll dominate the industry just as they did in 2008. In fact, the financial crisis increased concentration because some TBTF institutions acquired the assets of other troubled TBTF institutions." 127 Because the TBTF banks have actually gotten larger since the crisis, the regulatory environment has become even more difficult, and adding new regulatory bodies does not help remediate this. So what concrete policies would help avoid a similar crisis in the future? One: Re define the federal safety net The FDIC wa s founded to secure the assets of depositors, not of shareholders. But as has been discussed above, the developments of the last two decades have resulted in an 126 Federal Reserve Bank of Dallas, Choosing the Road to Prosperity 6. 127 Ibid, 21.
91 overextension of the federal government's safety net. This, in turn, discourages market discipl ine and encourages reckless behavior by institutions whose actions can have catastrophic effects upon the rest of the economy. If the TBTF banks were allowed to fail properly, without government nationalization of private financial assets, it is unlikely t hat the shareholders with a stake in these institutions would allow for the sort of mismanagement that took place in the years before the crisis. In short: we must make it so that investors and creditors have money to lose, skin in the game, in case of mis management. Two: Break up the TBTF banks The most apt medicine for this disease is the end of TBTF. In radical terms: we should break up the largest Wall Street banks. For all their promise of stability and efficiency, they have become a liability due t o their complexity. Due in great part to the size they have achieved, these banks have become much too complex to manage. If banks were broken up into small pieces each piece would become more manageable, and therefore any trouble could be more readily app rehended and remedied. The problem with this solution, however, is that it is to expensive, politically speaking. Trust busting is not a fashionable proposal, and anybody who proposed such an initiative would be laughed at first and unseated second. A more modest proposal is to make it difficult for banks to remain operating as they have been. Three: Impose a tax on institutional opacity
92 Again, to be precise, the problem isn't necessarily that these institutions are too massive, it is that they are far t oo complex to be adequately regulated, or even managed. TBTF banks have branches, offices, and subsidiaries spread across the world, involved in widely different activities, with management structures that are simply not harmonized. A tax on organizational complexity would encourage banks to streamline their organizational structures, so that they are easier to manage and easier to oversee. This proposal centers on adding a rating of complexity to the CAMELs rating, a rating utilized by the FDIC to evaluate financial institutions. 128 If an investment bank scored well on the other five categories (Capital, Asset Quality, Management, Earnings, Asset Liability Management) but scored poorly on the Organizational complexity category, it would raise the risk profile of that institution, attracting the attention of both management and government regulators. Should this category be instituted into the ratings system, it would effectively impose a tax on organizational opaqueness, driving institutions away from the TBTF model which stands at the crux of the financial sector's problems. Because imposing a tax on any economic activity discourages it, placing a tax on institutional complexity would encourage banks to simplify their structures and operations. This would make the banks easier to manage, as well as to regulate. Another tool which could help reduce the potential of these institutions to drag the economy with them during times of failure is the advancement of regulations which require government regulatory agenc ies to maintain contingency plans on file detailing how the assets of a TBTF institution may be recapitalized in the event of failure. This 128 Harvey Rosenblum, What Reforms Are Needed to Improve the Safety and Soundness of the Banking System? (Economic Review, 2007), 109.
93 would acknowledge that traditional methods of dealing with bank failure on the part of the Fed and the FDIC fail to meet the scope of TBTF failure. 129 With these measures in place, the government places renewed pressure on key institutions to streamline their organization, as well as make it more transparent. This will dissipate the obfuscation concerning the anti democr atic tendencies of oligopolistic markets and helpless regulators. Additionally, taking these measures will return a sense of contestation to a marketplace which has become all to complacent and corrupted. Perhaps more importantly, this kind of regulatory oversight, combined with a reduction in the complexity would open up the space for competition and market discipline, which is at the moment seriously lacking. With a more regulated, transparent, and competitive environment, the impregnability of the TBTF institutions, and with it the odds of a similar crisis re erupting will have been greatly diminished. 129 Ibid, 112.