Defaulting banks - where will it stop?

[Austin Kelley]

Excerpted from: http://www.rdwolff.com/content/teaching-...m’s-crisis

Teaching Capitalism’s Crisis

by Richard Wolff.



The Basic Analysis

This is not a financial crisis. It is rather a systemic crisis rooted in the conflicted relation between employers and employees across all capitalist enterprises in the United States. It flows from Main Street as much as from Wall Street. It engulfs households, enterprises, and the government. It is a crisis of capitalism and not merely of finance.

To see this, let’s take a brief look at U.S. history. For the 150 years from 1820 to around 1970, workers’ average productivity rose every decade. The hourly output of commodities rose because workers were better trained, had more and better machines, were more closely supervised, and had to work harder and faster. Over those same years, workers’ real wages (what their money wages actually afforded) also rose every decade. Because productivity rose faster than real wages, capitalists’ profits also rose faster than wages.

Thus our working class enjoyed 150 years of rising consumption as our capitalists enjoyed rising profits. No wonder U.S. workers would come to define individual self-worth and to measure success in life according to the standard of consumption: it kept rising. Successive generations of parents promised their children better standards of living and proudly kept those promises. Capitalists and workers could join in celebrating American exceptionalism since no other capitalism had such a long history of rising consumption.

But all that changed in the 1970s and never returned. Real wages stopped rising as U.S. corporations (1) moved operations abroad to pay lower wages and make higher profits, (2) replaced workers with machines (especially computers), and (3) hired ever more U.S. women and immigrants at lower wages than men received. Real wages in the later 1970s exceed real wages today.

Meanwhile, productivity—led by computerization—kept rising. Simply put, since the 1970s, what employers got from each worker kept rising while the real wages paid to each worker stagnated. The difference between rising outputs and stagnant wages—the source of capitalists’ profits—grew bigger and bigger. As employers’ profits exploded, those entitled to portions of those profits have done well: the managers they hire, the shareholders who get dividends and capital gains, and so on. The specialists who handled each employer’s mushrooming profit—the finance industry that invested it, lent and borrowed it, managed it, —thereby got growing portions of the rising profits.

What happened to a working class that measured individual success by rising consumption when it no longer had rising wages to pay for it? It could not and did not forego rising consumption. It found two other ways to cope and thereby laid the groundwork for one part of the current crisis. First, if individuals’ real wages per hour stagnate, earnings can rise if each household does more hours of paid labor. Thus, millions of housewives entered the paid labor force over the last 30 years while husbands took second jobs and both teenagers and retirees found paid work too. Today, we work on average 20 per cent more hours per year than workers in France, Germany and Italy.

With more household members out working, new costs and problems beset American families. Women wage-earners needed new clothes, a second car, and services like daycare, prepared food, psychotherapy, and drugs to handle new pressures and demands. Such extra costs soaked up women’s extra income; not enough remained to fund other expected and desired increases in household consumption. Moreover, households were badly strained by the exhaustion and stress of overworked spouses, alienated children, and growing rates of divorce, alcoholism, and drug dependency. In such conditions, the American working class took another step to maintain rising consumption levels. It borrowed money in unprecedented quantities. Soaring household debts proved to be another part of the groundwork of today’s crisis.

The U.S. business community then grasped a fantastic double opportunity. First, it could reap huge profits from the combination of flat wages and rising productivity. Second, it could lend a portion of those profits back to a working class traumatized by stagnant individual wages to enable it to consume more. Instead of paying their workers rising wages (as in the 1820-1970 period), employers (directly or through the banks) flooded very profitable loans onto desperate and often financially naive workers. For employers generally, and especially for financial corporations, this seemed truly a golden age, the validation of capitalism’s celebrated magic.

Underneath the magic, however, workers were increasingly exhausted, their families were disintegrating, and their anxieties were deepened by unsustainable debt levels. At the same time, banks, insurance companies and other financial enterprises profited by taking ever greater risks and by designing and selling ever more questionable securities to systematically misinformed investors. In those heady times, non-financial industries also took bigger risks believing that “the new economy” touted by Alan Greenspan would only ever expand. Before long, workers by the millions began to default on their debts. Then corporations did, too. The credit house of cards collapsed; housing prices tanked; and recession descended. The system had long celebrated the idea that this could not and so would not happen. When it did, nobody was prepared. Since mid-2008 the crisis has deprived millions of their jobs, income, homes, and wealth in the trillions. A desperate population demanded explanations and solutions, changes that would fix the economic disaster. It dumped Republicans and hoped for an economic revival from Obama.

Bush and then Obama poured trillions into the finance industry (guaranteeing the debts of and/or investing in the nation’s biggest banks and insurance companies). Obama then did likewise in organizing the bankruptcies of Chrysler and General Motors. The steps aimed to “kick-start the economy” or to “get the economy moving again” or to “fix the credit markets”: in short to resume the happy state of the economy before the crisis hit in 2008.

This strategy is absurd because were it to succeed (far from certain), it would only return the economy to the web of problems that produced the crisis. This strategy fails to take account of those problems and their historical depth. An exhausted, anxious, and over-indebted working class cannot sustain a widely corrupted, bankrupt, or over-leveraged corporate sector and a government now adding trillions to its national debt.

Another Obama strategy favors government re-regulation especially of the finance industry. The premise is that deregulation since the 1970s caused the crisis. Yet the history of past regulations in the United States challenges such a strategy. FDR’s New Deal did regulate (the social security system, unemployment insurance, restrictions on bank and insurance companies, new business taxes, labor relations, constraints on businesses). Regulation was intended not only to overcome the collapse of capitalism in the 1930s but to prevent future collapses. Neither intention was realized. The Great Depression persevered despite regulations; only World War II finally ended it. Moreover, because regulations impeded profitability and growth, employers had strong incentives to evade, undermine, and, if possible, destroy them. After World War II, many corporate boards of directors spent lavishly on lobbying, funding think tanks, bribing, and campaigning in the mass media to undo almost all of them.

The 1930s regulations not only gave employers incentives to undermine them; they also left employers in the position to decide on the uses made of enterprises’ profits. Employers could and indeed did use those profits to undermine regulations. That is the history of regulations from the 1930s to this day. Like FDR’s, Obama’s proposed regulations thus display a built-in self-destruct button.

A reasonable solution now must learn the lessons of past capitalist crises. Today’s government bailouts, regulations, etc. must not reproduce that self-destruct button. Boards of directors must be deprived of the incentives and resources that have ended up negating the rules and controls that aim to make economic activity serve social needs. This requires a basic change: the workers in every enterprise should become collectively their own board of directors. For the first time in American history, the workers who depend on a socially regulated economy would then occupy the position of receiving enterprise profits and using them to make regulations succeed rather than sabotaging them.

This proposal for workers to collectively become their own board of directors also democratizes the enterprise. It gives the majority in every enterprise the power to decide what is produced, how and where it is produced, and what is done with the proceeds. Such economic democracy inside enterprises is not only a necessary crisis response; it also fosters real democracy across society as workers will demand similar democracy in the communities where they live. Finally, the desire of the mass of people to hold meaningful and decently paid jobs, to live and also work democratically, would then no longer be undone by their employers. In our capitalist system, the employers are chiefly corporate boards of directors and those coporations’ major shareholders. They retain the power, incentives, and resources both to generate crises and to resist effective means to prevent them. That system is the underlying cause of and problem for today’s global crisis. It is long overdue for a basic change.



***


Wolff's video is also quite worthwhile:


http://www.capitalismhitsthefan.com/

[Magda Hassan]

This is not a financial crisis. It is rather a systemic crisis rooted in the conflicted relation between employers and employees across all capitalist enterprises in the United States. It flows from Main Street as much as from Wall Street. It engulfs households, enterprises, and the government. It is a crisis of capitalism and not merely of finance.

Absolutely Austin. This is overlooked by most and never mentioned by the MSM. 'They' would like us to believe that 'There Is No Alternative' to capitalism and that it is inevitable and the natural state of things and these sorts of crisis are just some thing we must endure like rain and wind and day and night. There was no Depression in the USSR as there was in the 1930's Europe and US. There are plenty of alternatives. Some much better than others.

[Jan Klimkowski]

According to the Daily Telegraph (aka the Torygraph), the EU is pressuring Britain to stump up some cash to keep the Ponzi scheme afloat.

The Torygraph is an organ of Euro-sceptic, right-wing, platitudes, infested with MI5 and MI6 assets, and it ain't happy.

If the Tories form a minority government early this week, they will probably veto any promise of British money to the Euro banker slush fund. Not for economic reasons, but because of their pathological hatred of foreigners.

So, in this instance, the Tories will be doing the right thing (not giving yet more taxpayer money to the banker Ponzi scheme), for the wrong reasons (Little Englander small brained nonsense).

British taxpayers ordered to bail out euro

Britain faces paying out billions of pounds under a European Union deal intended to prevent another financial crisis like the one in Greece.

By Bruno Waterfield and Melissa Kite
Published: 9:00PM BST 08 May 2010

All 27 EU finance ministers have been summoned to Brussels on Sunday to sign up to a “European stabilisation mechanism. Britain will be unable to veto this as it will be put through under the “qualified majority voting” system.

The deal, effectively to shore up the euro, was denounced as a “stitch-up” last night after it emerged Nicolas Sarkozy, the French President and Angela Merkel, the German Chancellor, had devised it behind closed doors and were attempting to push it through at a time when there is no clear government in Britain.

It was declared a "done deal” by the 16 euro zone leaders who met in the early hours of Saturday morning.

The decision was taken as David Cameron was locked in talks with the Liberal Democrats to try to form a government.

Alistair Darling, the Chancellor, will fly to Brussels for the meeting after promising to keep George Osborne and Vince Cable, his Tory and Lib Dem counterparts, informed. EU finance ministers have been given the deadline of midnight tonight to agree the highly sensitive but rushed proposals to protect the single currency from financial turbulence from the Greek debt crisis.

“When the markets reopen Monday we will have in place a mechanism to defend the euro,” said President Sarkozy yesterday. “This is a full-scale mobilisation.”

Euro-zone leaders are attempting to get round objections from countries such as Britain by invoking Article 122 of the Lisbon Treaty, intended to enable a collective response to natural disasters. This does not need unanimous agreement.

By doing so, Mr Sarkozy has ensured a speedy confrontation with a new British prime minister and other leaders of non-euro currency countries. All 27 EU finance ministers must be present, but because decision will be taken by qualified majority vote, the 16 euro zone leaders can ensure its passage.

British exposure to liabilities created by a bail-out under the scheme would amount to around 10 per cent of the total loan. If a country failed to repay, the cost to Britain would be ¤10 billion (£8.6 billion) for every ¤100 billion on which it defaulted.

The scheme will present an immediate dilemma for an incoming Conservative government. A bail-out would increase British liabilities and debt at a time when Mr Cameron would be seeking to restrain spending.

Refusal to lend the money would plunge a Tory prime minister, overseeing a coalition or minority government, into a damaging conflict with the EU.

Euro-zone leaders took the decision as a two-hour dinner on Friday stretched into nine hours of tense negotiations.

Action is being called for because Spain and Portugal are showing the same early symptoms of crisis that Greece showed three months ago. Borrowing costs for indebted euro-zone countries have soared amid signs that market fears could spread across all EU countries, including Britain.

José Manuel Barroso, the European Commission President said: “We will defend the euro, whatever it takes.”

British officials are concerned that the EU is preparing to use the sweeping Lisbon Treaty clause as the legal basis for a European bailout scheme.

Under the clause, an EU member state hit by “natural disasters or exceptional occurrences beyond its control” can receive “financial assistance” after a qualified majority vote by European leaders.

Supporters of the plan argue that “exceptional circumstances” includes market “attacks” on the euro.

”The euro’s 16 countries have already agreed it - that’s a majority," said a diplomat. "It’s a fait accompli. Those not in the euro - Britain, Poland, Sweden and other new EU members - can’t stop this."

Officials and diplomats have confirmed that Gordon Brown, the Prime Minister, was the last non-eurozone leader to be telephoned on Friday night by José Luis Rodríguez Zapatero, his Spanish oppositer number, to be warned about the EU plan.

Europe’s failure to contain Greece’s fiscal crisis last week triggered a 4.3 per cent drop in the euro and threatened to spark a global debt crisis.

Mats Persson, the director of Open Europe, said that while euro zone stability was in Britain’s interests, the bailout deal was not.

”This latest move could make British taxpayers liable for the debts of governments over which they have no democratic control - to the tune of billions of pounds,” he said.

”A British government, of whatever persuasion, must really consider whether it should take part in centralised EU borrowing on this scale, not least since such facilities were always considered illegal under the EU treaties and wholly undemocratic.”

http://www.telegraph.co.uk/news/worldnew...-euro.html

[Jan Klimkowski]

Darling has now said that Britain won't bail out the Euro.

However, it looks as if the ECB will go ahead anyway - with a Euros 600 billion loan facility being mooted to prop up the Ponzi scheme.

The spooky Torygraph's spooky Ambrose Evans-Pritchard has worked himself up into a lather:

Europe prepares nuclear response to save monetary union

Are Europe's leaders grasping the nettle at last?

Faced with the imminent disintegration of monetary union, they appear poised to create the beginnings of an EU debt union and authorize the European Central Bank to step in immediately to stabilize the eurozone bond markets.

By Ambrose Evans-Pritchard
Published: 7:54PM BST 09 May 2010

"It is an absolute general mobilization: we have decided to give the eurozone a veritable economic government," said French president Nicolas Sarkozy, once again basking as Europe's action man. "Today we have an attack on the whole of the eurozone. This is a systemic crisis: the response must be systemic. When the markets open on Monday morning we will be ready to defend the euro."

Great caution is in order. German Chancellor Angela Merkel has so far said little. The descriptions of the deal agreed by EU leaders in the early hours of Saturday are coming from the French bloc and EU bureaucrats. How many times during the Greek saga of the last four months have we heard claims from Brussels that turned out to be a distortion of what Germany had actually agreed, causing each relief rally to falter within days? They had better get it right this time.

if the early reports are near true, the accord profoundly alters the character of the European Union. The walls of fiscal and economic sovereignty are being breached. The creation of an EU rescue mechanism with powers to issue bonds with Europe's AAA rating to help eurozone states in trouble -- apparently €60bn, with a separate facility that may be able to lever up to €600bn -- is to go far beyond the Lisbon Treaty. This new agency is an EU Treasury in all but name, managing an EU fiscal union where liabilities become shared. A European state is being created before our eyes.

No EMU country will be allowed to default, whatever the moral hazard. Mrs Merkel seems to have bowed to extreme pressure as contagion spread to Portugal, Ireland, and -- the two clinchers -- Spain and Italy. "We have a serious situation, not just in one country but in several," she said.

The euro's founding fathers have for now won their strategic bet that monetary union would one day force EU states to create the machinery needed to make it work, or put another way that Germany would go along rather than squander its half-century investment in Europe's power-war order.

Whether the German nation will acquiesce for long is another matter. Popular fury over the Greek rescue has already cost Mrs Merkel control over North Rhine-Westphalia and with it the Bundesrat, dooming her reform agenda. The result was a rout.Events are getting out of hand, and not just on the streets of Athens.

AE-P's rhetoric continues for another page or two here:

http://www.telegraph.co.uk/finance/finan...union.html

[Jan Klimkowski]

The game is almost up.

Germany and France (aka the EU) just went all in with their ridiculous Euros 7-800 billion raise.

The vulture speculators will call their bet, (with funny money against our taxpayer cash - see below), and raise.

The dealer is preparing to push the entire global pot towards the vultures.

Jim Rickards: "Goldman Can Create Shorts Faster Than Europe Can Print Money"

Submitted by Tyler Durden on 05/10/2010 12:04 -0500

Jim Rickards, who recently has gotten massive media exposure on everything from the JPM Silver manipulation scandal, to the Greek default, was back on CNBC earlier with one of the most fascinating insights we have yet heard from anyone, which demonstrates beyond a doubt why any attempt by Europe to print its way out of its current default is doomed: "Look at what Soros did to the Bank of England in 1992 - he went after them, they had a finite amount of dollars, he was selling sterling and taking the dollars, and they were buying the sterling and selling the dollars to defend the peg. All he had to do was sell more than they had and he wins. But he needed real money to do that. Today you can break a country, you don't need money you just need synthetic euroshorts or CDS. A trillion dollar bailout: Goldman can create 10 trillion of euroshorts. So it just dominates whatever governments can do. So basically Goldman can create shorts faster than Europe can create money." Just wait until Europe finally realizes that the CDS "speculators" had all the cards in the poker game all along. And we hope Europe listens to the man: being LTCM's GC he knows all about failed bail outs.

http://www.zerohedge.com/article/jim-ric...rint-money

[Jan Klimkowski]

CDS Traders Beating The UK Death Drums

Submitted by Tyler Durden on 05/12/2010 08:25 -0500


As we pointed out last week, nobody cares about either Greece or the PIIGs any more. The focus among the smartest money out there, in the face of CDS traders, for the third week running, is on the core of Europe, and specifically on the UK. Last week the net notional derisking in UK was a massive $1,063 million in 280 traded contracts, which according to our files is the single biggest one week derisking amount on record. all the Greek "speculators" are now focusing their attention squarely on the UK... and France, which came in second with $384 million in derisking. Incidentally, these two represented the greatest amount of of derisking in all top 1000 CDS reference names (third altogether was not surprisingly Goldman Sachs with $256 million). The bet is now squarely on that the PIIGS contagion will move to the UK, and that France will also not be spared. We wish Mr. Cameron all the best as he attempts to push the $50 billion austerity measure through. We have a feeling his popularity rating in under a year will be even lower than that of president Obama. And if it isn't it will be because the cable and the dollar will be at parity. After all, we are all money devaluing comrades now.

Top 10 sovereign deriskers:

(Charts at url)

http://www.zerohedge.com/article/cds-tra...eath-drums

[Jan Klimkowski]

The European Central Bank is now behaving entirely illegally as a European Plunge Protection Team to protect the interests of bankers and the financial elites:

Meet The Latest Member Of The Plunge Protection Team: The European Central Bank

Submitted by Tyler Durden on 05/20/2010 12:34 -0500

Ben Bernanke European Central Bank Trichet


The long-debated topic of whether the ECB intervenes on behalf of the euro can now be put to rest. 120 pip move in a minutes is not a short cover. It is, and always has been, forced central bank intervention. Bernanke is so happy Trichet is doing his work for him for the time being. Be very wary of buying stocks on this intervention, as Central Bank involvement now at best leads to a 12 hour temporary "fix" to the market that Bernanke et al want to sustain.

(Chart at url revealing the ECB PPT intervention)

http://www.zerohedge.com/article/meet-la...ntral-bank

[Jan Klimkowski]

The international speculators turn their electroshock prods on Hungary:

Hungary Vows to Avert Greece-Like Crisis

By VERONIKA GULYAS and MARGIT FEHER

BUDAPEST—Hungary's new government Friday failed to calm financial markets that were roiled by a senior official's warning that the country faces a Greece-style fiscal meltdown.

The Hungarian forint tanked in currency markets, where the euro was also coming under pressure, on remarks Thursday by the vice president of the Fidesz party, Lajos Kosa, that Hungary is in a Greece-like sovereign credit crisis.


A spokesman for Prime Minister Viktor Orban declined to comment on the official's remarks. Spokesman Peter Szijjarto said the new government was committed to prevent a Greece-like crisis, but claimed Hungary was in a severe situation.

"The government is ready to avert the Greek road," he said, but warned that the budget deficit could be deeper than previously assumed and that the Hungarian economy would need to be reformed.

"There is nobody in the country apart from the previous government who still says the budget deficit of 3.8% of gross domestic product can be reached," said Mr. Szijjarto. He was referring to the budget-deficit agreed previously with the International Monetary Fund, which is supporting Hungary with stand-by loan agreements.

His remarks did little to calm fears in financial markets, where investors worried that the new government could soon announce worse news from Hungary's Treasury.

In credit markets, the cost of insuring Hungarian sovereign debt against default rose to its highest level since July 2009. Hungary's five-year credit-swap spreads—a key measure of credit risk—stood at 0.43 percentage point. That is over one percentage point wider on the day and 1.8 points on the week.

"You simply cannot talk like this in these markets," said Timothy Ash, head of emerging market research at Royal Bank of Scotland.

Economists were also left confused by apparent conflicting signals from the new center-right Fidesz government, which has said it plans to give a state-of-the-budget statement over the weekend.
MarketBeat

* Really? Now We're Worried About Hungary?

Fidesz won parliamentary elections in April in a landslide victory, unseating the minority Socialist government that implemented painful austerity measures to regain investor confidence.
That hard-earned confidence could evaporate quickly unless the comments are a prelude to some further fiscal measures. "We see the comments as a pre-warning/excuse to continue fiscal prudence," said Nordea economist Elisabeth Andrew. "The communication technique was clumsy, however, and caused market confusion."

The government said it would start the economic reorganization once the findings of a committee investigating the "true" state of the budget are published. Mr. Szijjarto didn't go into details on the reorganization, but said it won't happen under previous methods of "patchworking" and austerity measures as these failed when the socialist government was at the helm.

The committee, headed by Chief of Staff Mihaly Varga, will report to the government over the weekend, and the findings will be published "within 72 hours" from then, said Mr. Szijjarto.
— Clare Connaghan in London contributed to this article.

http://online.wsj.com/article/SB10001424...TopStories

[Jan Klimkowski]

Soros can never be taken at face value.

With that caveat, his piece below contains several astute insights - particularly around the absolute failure of orthodox economic free market theory and its true status as a pseudo or anti-science serving as a fig leaf for elite looting:

'We have just entered Act II of the drama'

By George Soros

June 11, 2010

In the week following the bankruptcy of Lehman Brothers on Sept. 15, 2008 — global financial markets actually broke down, and by the end of the week, they had to be put on artificial life support. The life support consisted of substituting sovereign credit for the credit of financial institutions, which ceased to be acceptable to counterparties.

As Mervyn King of the Bank of England brilliantly explained, the authorities had to do in the short term the exact opposite of what was needed in the long term: they had to pump in a lot of credit to make up for the credit that disappeared, and thereby reinforce the excess credit and leverage that had caused the crisis in the first place. Only in the longer term, when the crisis had subsided, could they drain the credit and re-establish macroeconomic balance.

This required a delicate two-phase maneuver just as when a car is skidding. First you have to turn the car into the direction of the skid and only when you have regained control can you correct course.

The first phase of the maneuver has been successfully accomplished — a collapse has been averted. In retrospect, the temporary breakdown of the financial system seems like a bad dream. There are people in the financial institutions that survived who would like nothing better than to forget it and carry on with business as usual. This was evident in their massive lobbying effort to protect their interests in the Financial Reform Act that just came out of Congress. But the collapse of the financial system as we know it is real, and the crisis is far from over.

Indeed, we have just entered Act II of the drama, when financial markets started losing confidence in the credibility of sovereign debt. Greece and the euro have taken center stage, but the effects are liable to be felt worldwide. Doubts about sovereign credit are forcing reductions in budget deficits at a time when the banks and the economy may not be strong enough to permit the pursuit of fiscal rectitude. We find ourselves in a situation eerily reminiscent of the 1930s. Keynes has taught us that budget deficits are essential for counter cyclical policies, yet many governments have to reduce them under pressure from financial markets. This is liable to push the global economy into a double dip.

It is important to realize that the crisis in which we find ourselves is not just a market failure but also a regulatory failure, and even more importantly, a failure of the prevailing dogma about financial markets. I have in mind the Efficient Market Hypothesis and Rational Expectation Theory. These economic theories guided, or more exactly misguided, both the regulators and the financial engineers who designed the derivatives and other synthetic financial instruments and quantitative risk management systems which have played such an important part in the collapse. To gain a proper understanding of the current situation and how we got to where we are, we need to go back to basics and re-examine the foundation of economic theory.

I have developed an alternative theory about financial markets which asserts that financial markets do not necessarily tend toward equilibrium; they can just as easily produce asset bubbles. Nor are markets capable of correcting their own excesses. Keeping asset bubbles within bounds have to be an objective of public policy. I propounded this theory in my first book, “The Alchemy of Finance,” in 1987. It was generally dismissed at the time, but the current financial crisis has proven, not necessarily its validity, but certainly its superiority to the prevailing dogma.

Let me briefly recapitulate my theory for those who are not familiar with it. It can be summed up in two propositions. First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. This is the principle of fallibility. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced. When there is a significant divergence between market prices and the underlying reality I speak of far from equilibrium conditions. That is where we are now.

Second, financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect. These two functions that financial markets perform work in opposite directions. In the passive or cognitive function, the fundamentals are supposed to determine market prices. In the active or manipulative function market, prices find ways of influencing the fundamentals. When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other, so that neither function has a truly independent variable. As a result, neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified. I call the interaction between the two functions reflexivity. Frank Knight recognized and explicated this element of unquantifiable uncertainty in a book published in 1921, but the Efficient Market Hypothesis and Rational Expectation Theory have deliberately ignored it. That is what made them so misleading.

Reflexivity sets up a feedback loop between market valuations and the so-called fundamentals which are being valued. The feedback can be either positive or negative. Negative feedback brings market prices and the underlying reality closer together. In other words, negative feedback is self-correcting. It can go on forever, and if the underlying reality remains unchanged, it may eventually lead to an equilibrium in which market prices accurately reflect the fundamentals. By contrast, a positive feedback is self-reinforcing. It cannot go on forever because eventually, market prices would become so far removed from reality that market participants would have to recognize them as unrealistic. When that tipping point is reached, the process becomes self-reinforcing in the opposite direction. That is how financial markets produce boom-bust phenomena or bubbles. Bubbles are not the only manifestations of reflexivity, but they are the most spectacular.

In my interpretation equilibrium, which is the central case in economic theory, turns out to be a limiting case where negative feedback is carried to its ultimate limit. Positive feedback has been largely assumed away by the prevailing dogma, and it deserves a lot more attention.

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow and more and more people lose faith, but the prevailing trend is sustained by inertia. As Chuck Prince, former head of Citigroup, said, “As long as the music is playing, you’ve got to get up and dance. We are still dancing.” Eventually a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions. Disillusionment turns into panic, reaching its climax in a financial crisis.

The simplest case of a purely financial bubble can be found in real estate. The trend that precipitates it is the availability of credit; the misconception that continues to recur in various forms is that the value of the collateral is independent of the availability of credit. As a matter of fact, the relationship is reflexive. When credit becomes cheaper, activity picks up and real estate values rise. There are fewer defaults, credit performance improves, and lending standards are relaxed. So at the height of the boom, the amount of credit outstanding is at its peak, and a reversal precipitates false liquidation, depressing real estate values.

The bubble that led to the current financial crisis is much more complicated. The collapse of the subprime bubble in 2007 set off a chain reaction, much as an ordinary bomb sets off a nuclear explosion. I call it a superbubble. It has developed over a longer period of time, and it is composed of a number of simpler bubbles. What makes the superbubble so interesting is the role that the smaller bubbles have played in its development.

The prevailing trend in the superbubble was the ever-increasing use of credit and leverage. The prevailing misconception was the belief that financial markets are self-correcting and should be left to their own devices. President Reagan called it the “magic of the marketplace,” and I call it market fundamentalism. It became the dominant creed in the 1980s. Since market fundamentalism was based on false premises, its adoption led to a series of financial crises. Each time, the authorities intervened, merged away, or otherwise took care of the failing financial institutions, and applied monetary and fiscal stimuli to protect the economy. These measures reinforced the prevailing trend of ever-increasing credit and leverage, and as long as they worked, they also reinforced the prevailing misconception that markets can be safely left to their own devices. The intervention of the authorities is generally recognized as creating amoral hazard; more accurately it served as a successful test of a false belief, thereby inflating the superbubble even further.

It should be emphasized that my theories of bubbles cannot predict whether a test will be successful or not. This holds for ordinary bubbles as well as the superbubble. For instance, I thought the emerging market crisis of 1997-98 would constitute the tipping point for the superbubble, but I was wrong. The authorities managed to save the system and the superbubble continued growing. That made the bust that eventually came in 2007-8 all the more devastating.

What are the implications of my theory for the regulation of the financial system?

First and foremost, since markets are bubble-prone, the financial authorities have to accept responsibility for preventing bubbles from growing too big. Alan Greenspan and other regulators have expressly refused to accept that responsibility. If markets can’t recognize bubbles, Greenspan argued, neither can regulators — and he was right. Nevertheless, the financial authorities have to accept the assignment, knowing full well that they will not be able to meet it without making mistakes. They will, however, have the benefit of receiving feedback from the markets, which will tell them whether they have done too much or too little. They can then correct their mistakes.

Second, in order to control asset bubbles it is not enough to control the money supply; you must also control the availability of credit. This cannot be done by using only monetary tools; you must also use credit controls. The best-known tools are margin requirements and minimum capital requirements. Currently, they are fixed irrespective of the market’s mood, because markets are not supposed to have moods. Yet they do, and the financial authorities need to vary margin and minimum capital requirements in order to control asset bubbles.

Regulators may also have to invent new tools or revive others that have fallen into disuse. For instance, in my early days in finance, many years ago, central banks used to instruct commercial banks to limit their lending to a particular sector of the economy, such as real estate or consumer loans, because they felt that the sector was overheating. Market fundamentalists consider that kind of intervention unacceptable, but they are wrong. When our central banks used to do it, we had no financial crises to speak of. The Chinese authorities do it today, and they have much better control over their banking system. The deposits that Chinese commercial banks have to maintain at the People’s Bank of China were increased 17 times during the boom, and when the authorities reversed course, the banks obeyed them with alacrity.

Third, since markets are potentially unstable, there are systemic risks in addition to the risks affecting individual market participants. Participants may ignore these systemic risks in the belief that they can always dispose of their positions, but regulators cannot ignore them because if too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or a collapse. They have to monitor the positions of participants in order to detect potential imbalances. That means that the positions of all major market participants, including hedge funds and sovereign wealth funds, need to be monitored. The drafters of the Basel Accords made a mistake when they gave securities held by banks substantially lower risk ratings than regular loans: they ignored the systemic risks attached to concentrated positions in securities. This was an important factor aggravating the crisis. It has to be corrected by raising the risk ratings of securities held by banks. That will probably discourage loans, which is not such a bad thing.

Fourth, derivatives and synthetic financial instruments perform many useful functions, but they also carry hidden dangers. For instance, the securitization of mortgages was supposed to reduce risk through geographical diversification. In fact, it introduced a new risk by separating the interest of the agents from the interest of the owners. Regulators need to fully understand how these instruments work before they allow them to be used, and they ought to impose restrictions guard against those hidden dangers. For instance, agents packaging mortgages into securities ought to be obliged to retain sufficient ownership to guard against the agency problem.

Credit-default swaps (C.D.S.) are particularly dangerous. They allow people to buy insurance on the survival of a company or a country while handing them a license to kill. C.D.S. ought to be available to buyers only to the extent that they have a legitimate insurable interest. Generally speaking, derivatives ought to be registered with a regulatory agency just as regular securities have to be registered with the S.E.C. or its equivalent. Derivatives traded on exchanges would be registered as a class; those traded over-the-counter would have to be registered individually. This would provide a powerful inducement to use exchange traded derivatives whenever possible.

Finally, we must recognize that financial markets evolve in a one-directional, nonreversible manner. The financial authorities, in carrying out their duty of preventing the system from collapsing, have extended an implicit guarantee to all institutions that are “too big to fail.” Now they cannot credibly withdraw that guarantee. Therefore, they must impose regulations that will ensure that the guarantee will not be invoked. Too-big-to-fail banks must use less leverage and accept various restrictions on how they invest the depositors’ money. Deposits should not be used to finance proprietary trading. But regulators have to go even further. They must regulate the compensation packages of proprietary traders to ensure that risks and rewards are properly aligned. This may push proprietary traders out of banks, into hedge funds where they properly belong. Just as oil tankers are compartmentalized in order to keep them stable, there ought to be firewalls between different markets. It is probably impractical to separate investment banking from commercial banking as the Glass-Steagall Act of 1933 did. But there have to be internal compartments keeping proprietary trading in various markets separate from each other. Some banks that have come to occupy quasi-monopolistic positions may have to be broken up.

While I have a high degree of conviction on these five points, there are many questions to which my theory does not provide an unequivocal answer. For instance, is a high degree of liquidity always desirable? To what extent should securities be marked to market? Many answers that followed automatically from the Efficient Market Hypothesis need to be re-examined.

It is clear that the reforms currently under consideration do not fully satisfy the five points I have made, but I want to emphasize that these five points apply only in the long run. As Mervyn King explained, the authorities had to do in the short run the exact opposite of what was required in the long run. And as I said earlier, the financial crisis is far from over. We have just ended Act II. The euro has taken center stage, and Germany has become the lead actor. The European authorities face a daunting task: they must help the countries that have fallen far behind the Maastricht criteria to regain their equilibrium while they must also correct the deficiencies of the Maastricht Treaty which have allowed the imbalances to develop. The euro is in what I call a far-from-equilibrium situation. But I prefer to discuss this subject in Germany, which is the lead actor, and I plan to do so at the Humboldt University in Berlin on June 23. I hope you will forgive me if I avoid the subject until then.

http://www.theage.com.au/business/we-hav...-y1rs.html

[Peter Lemkin]

Wall Street’s War Against Main Street America

by Prof. Michael Hudson


Global Research, February 17, 2010

Former Treasury Secretary Hank Paulson wrote an op-ed in The New York Times, (Feb. 16)[1] outlining how to put the U.S. economy on rations. Not in those words, of course. Just the opposite: If the government hadn’t bailed out Wall Street’s bad loans, he claims, “unemployment could have exceeded the 25 percent level of the Great Depression.” Without wealth at the top, there would be nothing to trickle down.



The reality, of course, is that bailing out casino capitalist speculators on the winning side of A.I.G.’s debt swaps and CDO derivatives didn’t save a single job. It certainly hasn’t lowered the economy’s debt overhead. But matters will soon improve, if Congress will dispel the present cloud of “uncertainty” as to whether any agency less friendly than the Federal Reserve might regulate the banks.



Mr. Paulson spelled out in step-by-step detail the strategy of “doing God’s work,” as his Goldman Sachs colleague Larry Blankfein sanctimoniously explained Adam Smith’s invisible hand. Now that pro-financial free-market doctrine is achieving the status of religion, I wonder whether this proposal violates the separation of church and state. Neoliberal economics may be a travesty of religion, but it is the closest thing to a Church that Americans have these days, replete with its Inquisition operating out of the universities of Chicago, Harvard and Columbia.



If the salvation is to give Wall Street a free hand, anathema is the proposed Consumer Financial Protection Agency intended to deter predatory behavior by mortgage lenders and credit-card issuers. The same day that Mr. Paulson’s op-ed appeared, the Financial Times published a report explaining that “Republicans say they are unconvinced that any regulator can even define systemic risk. … the whole concept is too vague for an immediate introduction of sweeping powers. …” Republican Senator Bob Corker from Tennessee was willing to join with the Democrats “to ensure ‘there is not some new roaming regulator out there … putting companies unbeknownst to them under its regime.’”[2]



Mr. Paulson uses the same argument: Because the instability extends not just to the banks but also to Fannie Mae and Freddie Mac, Lehman Brothers, A.I.G. and Wall Street underwriters, it would be folly to try to regulate the banks alone! And because the financial sector is so far-flung and complex, it is best to leave everything deregulated. Indeed, there simply is no time to discuss what kind of regulation is appropriate, except for the Fed’s familiar protective hand: “delays are creating uncertainty, undermining the ability of financial institutions to increase lending to businesses of all sizes that want to invest and fuel our recovery.” So Mr. Paulson’s crocodile tears are all for the people. (Except that the banks are not lending at home, but are shoveling money out of the U.S. economy as fast as they can.)



As Mr. Obama’s chief of staff Emanuel Rahm put it, a crisis is too good a thing to waste. It’s a con man’s old trick to pressure the victim to make a decision fast. Having created the crisis, Wall Street wants to use its momentum to knock out any potential checks to its power. “No systemic risk regulator, no matter how powerful, can be relied on to see everything and prevent future problems,” Mr. Paulson explained. “That’s why our regulatory system must reinforce the responsibility of lenders, investors, borrowers and all market participants to analyze risk and make informed decisions,” In other words, blame the victims! The way to protect victims of predatory bank lending (and crooked sales of junk securities) is not new regulations but just the opposite: “to simplify the patchwork quilt of regulatory agencies and improve transparency so that consumers and investors can punish excesses through their own informed investing decisions.” Simplification means the Fed, not a Consumer Financial Protection Agency.



Moving in for the kill, Mr. Paulson explains that the Treasury is bare, having used $13 trillion to bail out high finance in 2008-09. So he warns the government not to run a Keynesian-type budget deficit. The federal budget should move into balance or even surplus, even if this accelerates the rise in unemployment and decline in wage levels as the economy moves deeper into recession and debt deflation. “We must also tackle what is by far our greatest economic challenge — the reduction of budget deficits — a big part of which will involve reforming our major entitlement programs: Medicare, Medicaid and Social Security.” The economy thus is to be sacrificed to Wall Street rather than reforming finance so that it serves the economy more productively. It is simple mathematics to see that if the government cannot raise taxes, it must scale back Social Security, other social welfare spending and infrastructure spending.



What is remarkably left out of account is that today’s financial crisis centered on public debts is largely fiscal crisis. It is caused by replacing progressive taxation with regressive taxes, and above all by untaxing finance and real estate. Take the case of California, where tears are being shed over the dismantling of the once elite University of California system. Since American independence, education has been financed by the property tax. But Proposition 13 has “freed” property from taxation – so that its rental value can be borrowed against and turned into interest payments to banks. California’s real estate costs are just as high with its property taxes frozen, but the rising rental value of land has been paid to the banks – forcing the state to slash its fiscal budget or else raise taxes on labor and consumers.



The link between financial and fiscal crisis – and hence the need for a symbiotic fiscal-financial reform – is just as clear in Europe. The Greek government has pre-sold its tax revenues from roads and other infrastructure to Wall Street, leaving less future revenue to pay its public debt. To cap matters, paying income tax is almost voluntary for wealthy Greeks. Tax evasion is hardly necessary in the post-Soviet states, where property is hardly taxed at all. (The flat tax falls almost entirely on labor.)



Throughout the world, scaling back the 20th century’s legacy of progressive taxation and untaxing real estate and finance has led to a public debt crisis. Property income hitherto paid to governments is now paid to the banks. And although Wall Street has extracted $13 trillion in bailouts just since October 2008, the thought of raising taxes on wealth to pay just $1 trillion over an entire decade for Social Security or health insurance is deemed a crisis that would lead Wall Street to shut down the economy. It is telling governments to shift to a regressive tax system to make up the fiscal shortfall by raising taxes on labor and cutting back public spending on the economy at large. This is what is plunging economies from California to Greece and the Baltics into fiscal and financial crisis. Wall Street’s solution – to balance the budget by cutting back the government’s social contract and deregulating finance all the more – will shrink the economy and make the budget deficits even more severe.



Financial speculators no doubt will clean up on the turmoil.



Notes



[1] Henry M. Paulson Jr., “How to Watch the Banks,” New York Times op-ed., February 16, 2010

[2] Tom Braithwaite, “Senators oppose ‘systemic risk’ curbs,” Financial Times, February 16, 2010.