Taking Stock

Every once and a while you come across a post that speaks volumes to you, and seems to tie things together, at least in some parts of your thought universe. Yves Smith at Naked Capitalism had one this morning, where she included a recent speech by noted economist Jamie Galbraith, John Kenneth Galbraith's son, keynoting the 5th Annual Post-Keynesian Conference in Dijon, France: Bad Economic Thinking and What Got Us Into This Mess.

Galbraith looks at the three main threads that grew out of Keynes' work and shows us where they are today. I addressed this topic of why Keynes has been shot down in conservative circles in a July post: Why Have We Discarded Keynes? Please do read Galbraith's Dijon speech in the posting above. I will highlight key points that jumped out or me.

We have no consensus among economists about how the world works. Galbraith laments that the 2008 crisis gave economists a unique chance to step back and reevaluate; unfortunately nothing much changed, and there was precious little rethinking. The neoclassical/neoliberal worldview dominates Western thinking: consumers are rational; markets are efficient, except when government intervenes; markets can be modeled (dynamic stochastic general equilibrium models are the rage) but are hard to understand for non-mathematicians; demand (for goods, services, or labor) is never a problem; markets tend towards equilibrium; asset bubbles can't happen, and when they do, they are the exception that proves the rule; unemployment is mostly caused by people choosing not to work, or government regulatory interference in the market, or people not having the right skills (structural unemployment); government spending cannot create jobs because private people will hold back an equivalent amount of money to pay for the taxes this spending will require; deficits are inflationary; in a recession governments should lower taxes and cut spending, in other words, austerity is the key to growth.

This is the prevailing "economists' consensus" that rules in Washington DC, European capitals, The European Central Bank, and the IMF. Summers, Geithner, and Bernanke disagree with key parts of the neoliberal consensus, but they totally missed the housing bubble; they think markets work efficiently most of the time; and their thinking seems to allow no place for the institutional brokenness in the financial sector that took us down. Obama is being creamed by lots of smart progressive folks who believe he has been very badly advised by Summers, Geithner and Bernanke. They were fine, these critics say, during the liquidity crisis. They were downright lousy when it came to seeing, understanding, and acting to correct the "heart of darkness" at the center of our financial system. I count myself as one of those critics.

According to Galbraith, there are three threads flowing out of Keynes: one, originating with Wynne Godley, focuses on national accounts accounting and sectoral balances - this school leads to Modern Monetary Theory, which I addressed here; a second, originating with Hyman Minsky, argued that markets do not tend to equilibrium, and that greed propels a market to move out of balance in to increasing waves of instability; and third, Galbraith pere, Jamie's father, who focused on the institutional and legal framework, created with the New Deal, within which a workable capitalist system must be contained. This is the part of the Keynesian heritage that has been most completely overlooked.

Galbraith makes the fascinating point that economists don't really know what to do with the financial economy that is dealing with contract created products that bear no resemblance to the real economy. Economics in the "real economy" depends on the commodification of hard products and measurable services about which many rules and models can be devised. But contract-based products like mortgage backed securities or credit default swaps don't seem to make much sense, and, therefore, are not studied. Yet it is precisely this part of the economy that blew up.

Galbraith then makes a frightening assertion: the legal/institutional framework is greatly affected by technology, which overtime corrupts the system beyond repair. The financial system, specifically investment banks and the banks, have a terminal illness. Technology has rendered financial products completely unintelligible and have guaranteed a level of fraud and corruption that is totally untenable.

Stocks were simple: every share looks like every other share. But mortgages - that's a different story. Each mortgage is tied to a different house, in a different location, with a different owner. The opportunity for chaos and corruption to emerge out of computer generated models and programs used throughout the securitization daisy chain was and remains too great: bundle a group of mortgages; sell them; bundle them together with another group of mortgages; sell them again; collect a large group of bundles and put them into a trust that then supports a security offering; that before it is sold is presented and highly blessed by the rating agencies (AAA versus our US AA); then the security is sold to investors who have no idea what the quality of the collateral pool really is and do not realize that when the investment bank doing the deal did a check on whether the trust mortgages met the reps and warranties in the bond offering, and found out they did not, they would leave most of the mortgages in the pool, or substitute even worse mortgages in; and when the mortgage pool began performing badly, and the bank servicers had to manage large numbers of house foreclosures, they found out that the trusts did not really have the required and certified (by the large bank trustees) to be present notes and fully endorsed mortgages; so they had to create new paperwork from scratch, and since time was of the essence, they hired foreclosure mill law firms to "robosign" the documents.

And I'm leaving out some of the best/worst parts: predatory loans on the front end - loans that everyone in the chain knew would not be repaid, but no one cared, because eventually the investor owned the mortgages - not the originating bank, not the intermediate bundler, not the investment bank selling the security; MERS - Mortgage Electronic Registry System, a technology facilitated system that allowed computer tracking of mortgage assignments and transfers, and avoided that irritating detail of paying local real estate recording fees at each transfer stage (leading now to a massive problem in the court foreclosure process establishing chain of title and standing to foreclose - and this problem is only getting bigger); the creation of mortgage tranches, or levels/tiers that quite magically, using computer modeling, converted a very similar pile of junk into a security containing 70-80% perfectly safe AAA mortgages; and the synthetic collateralized debt obligations, where major players, who wanted to short the market, made credit default insurance payments into the trust, referencing a specific pool of mortgages (which they often helped to select), with their insurance payments mimicking real mortgage payments and the resulting "synthetic (no real mortgages at all) CDO" receiving a AAA rating, and these securities that were really just big short positions, gave a luster of continued energy to the entire mortgage market, and probably delayed the crash by two years.

When you study all of this in some detail, it is appalling. My Dad was CEO of the Quaker Oats Company, now part of Pepsi. I worked at Quaker for 12 years. Honesty, integrity, quality, service were key values. They were in the very air we breathed. It absolutely never occurred to me that an entire industry could go bad. Galbraith's point is that technology/computers/computer modeling has made large scale fraud and deception so extraordinarily easy. We all know how impressed we are when we see a multi-page computer spreadsheet report that shows us a giant pool of something or another, with a summary page showing how all the numbers add up in attractive ways, and we simply know it's going to be fine. This is what we have now. This is what caused the crisis. And the patient is terminally ill. As soon as the consumer starts buying again, this same process will restart, in some new corner of the financial universe.

There is much we must do. This post is already too long, so I will tackle the to do list tomorrow. A simple summary: regulation must be greatly stiffened; regulators have to regulate again; and most likely, our banks must be restructured. More tomorrow.