FINANCIAL CRISIS: THE SUB-PRIME TIP OF LAISSEZ-FAIRE AND TOO-BIG-TO-FAIL SUBSIDIES (THURSDAY AFTERNOON FACULTY SEMINARS) CYRUS BINA, PH.D. DISTINGUISHED RESEARCH PROFESSOR OF ECONOMICS UNIVERSITY OF MINNESOTA (MORRIS CAMPUS)窶年OVEMBER 5, 2009
STRATEGIC COMPETITION: ‘CREATIVE DESTRUCTION’ & ‘DESTRUCTIVE CREATION’
Fictional vs. Real Competition Competition: Concentration & Centralization of Capital Fast-Paced Technological Change & Hyper Competition Technological Change and the Role Finance Competition and Wholesale Destruction of capital Competition and the Restructuring Reality: No Production without Finance Relative Autonomy of Finance: Multiple Creation of IOU Lax Regulation, Profit Motive, and Churning of Money Finance for the Sake of Finance or Profit without Productive Activity
SECURITIZATION: FALSE SENSE OF SECURITY— Risk vs. Uncertainty: “Securitization" of the subprime housing market
and other risky financial assets and bundling of all "collateralized debt obligations" with the socalled asset-backed commercial paper, led to an awesome turnover of capital based on ad hoc and imaginary fictitious credit upon fictitious credit (that is, IOU upon IOU) for the purpose of rapid short-term gains with little or no cushion for actual security.
CALCULABLE RISK VS. UNCERTAINTY: A Conservative ‘Chicago Boy’ and a Cambridge Social Democrat— Frank Knight and John Maynard Keynes: The classic definition of what is known as risk (that is, calculable risk) refers to a phenomenon that effectively lends to calculation through application of probability theory, given the availability of information contained in its (readily known) probability distribution prior to its occurrence. Uncertainty is qualitatively distinct from ordinary risk in that its probability distribution is unknown prior to its occurrence. Hence it’s subject to Yogi Berra’s dictum: “It ain’t over till it’s over.” Hence the unconstrained piling up of incalculable risk upon incalculable risk is the stuff of uncertainty which exhibit an incredible level of non-linearity with complex chaotic patterns, and which would not readily submit to probability theory conventional probability calculations.
PARALLEL TRAGEDIES Shakespeare's Macbeth
(Act 5, Scene 3):
“I will not be afraid of death and bane*
Till Birnam Forest come to Dunsinane.”
Federal Reserve’s Macbeth
(Act 18.5, Scene 2008):
“What went wrong with global economic
policies that had worked so effectively for nearly four decades?”
________________ * Destruction.
SPREAD OF UNKOWN BY FIAT: ‘HUMAN NATURE’ OR IDIOTIC MARKET IDEOLOGY? Alan Greenspan— “It’s human nature: unless somebody can find a way to change human nature we will have another crisis.” “A critical pillar to market competition and free markets did break
down. I still do not fully understand why it happened.” “The Ideal political-economic system is laissez-faire capitalism”—
Ayn Rand (Alan Greenspan’s idol). “We are in the midst of a once-in-a century credit tsunami.” “Forecasting never gets to the point where it is 100 percent
accurate.”—Really!!!!!!!!!!!!!!!!!!!!!!!!!!!
CONTAGION SPREADS LIKE THE PLAGUE  The fallacy of supply-side economics and the myth of self-correcting markets, culminated in idealism of benign neglect and the straightjacket
practice of neo-liberal ideology. The resultant speculative bubbles in the U.S. real estate, mortgage institutions, collateralized debt obligation (CDO) market, asset-backed commercial paper market, and debt-obligation insurance market sequentially burst in the face of U.S. authorities, before hitting the public with vengeance and surpassing the boundaries of the United States - via the transnational channels.
TOO BIG TO FAIL: ‘INSTABILITY’ OF CAPITALISM Major Artery of Finance & Heart Attack Domino of Devaluation & Destruction of
Financial Capital Spread of Uncertainty to Remaining Sectors of the Economy The ‘Instability’ of Capitalism—Schumpeter’s Last Laugh! The Begging Bowl Syndrome and Ideology of Laissez-faire Glass-Steagell vs. Alan Greenspan John Maynard Keynes’ Last Laugh!
THE GLASS-STEAGALL ACT of 1933  The Glass-Steagall Act of 1933 established the
Federal Deposit Insurance Corporation (FDIC) in the United States and included banking reforms, some of which were designed to control speculation.[1] Some provisions such as Regulation Q, which allowed the Federal Reserve to regulate interest rates in savings accounts, were repealed by the Depository Institutions Deregulation and Monetary Control Act of 1980. Provisions that prohibit a bank holding company from owning other financial companies were repealed on November 12, 1999, by the Gramm-Leach-Bliley Act.
DEFAULT: SNOWBALLING IN REVERSE  US mortgage default reveals the tiny tip of the liquidity crisis in view
of tight credit market since the banking collapse.  Default in this segment of the market has led to the default of the
mortgage-holding institutions and, in due course, to the underwriting of the asset-backed commercial papers that had insured the amalgam of these collateral risks in the first place.  All this had come full circle: first leading to a substantial decline in
home prices across the board, which translated instantly to devaluation and thus evaporation of equity across the economic landscape , and then was passed on and spread to the layered network of financial institutions that reluctantly had to write-down hundreds of billions of dollars on their books.
CREDIT DEFAULT SWAPS: THE HOUSE OF CARDS?
What’s CDS? It ‘s an insurance contract between a protection buyer and a protection seller covering a corporate bond or loan. Buyer an upfront sum, plus annual premiums to seller in order to cover any loss on the face-value of bond or loan in question. Example: Hedge Funds.
CDS are unregulated private contracts between two parties that are subject only to the collateral and margin stipulated in the contract.
CDS are traded over-the-counter and subject to re-sale to any one willing to enter into another contract.
CDS are not transparent instruments of debt and not traded on any exchange—not subject to any securities laws.
AIG is a prima facie case which defaulted as an insurer and since the buyers were NOT covered, Uncle Sam had to step in so that this ‘too-bigto-fail’ entity do not take down the entire financial network to oblivion.
CREDIT DEFAULT SWAPS: THE HOUSE OF CARDS—Continue
CDS are also known as financial derivatives.
CDS market by its ad hoc, unlimited, and unregulated nature attracts the socalled risk speculators who do not own underlying credit but willing to speculate on these uncertain and make-belief instruments.
Mortgage-backed Securities are a familiar example.
Due to the illusive and un-transparent nature of CDS, even Federal Reserve has no idea how of these derivatives are currently floating in the market.
International Swap and Derivative Association (ISDA) estimates the notional value of credit default swaps (CDS) at $62 trillion. Yet there are estimates that would put the number at two times that. For a quick comparison, even the lower estimate of $62 trillion is two times the value of the U.S. stock market, mortgage market, U.S. treasuries market combined—a mindbugling phenomenon and potential earthquake, way beyond the Richter scale.
CHAOS THEORY & CHAOS PRACTICE!  Theory of Chaos, discovered in the 1960s, taught us: 1. Thinking linearly may not be stupid, but unrealistically stupid; 2. All systems (both natural and social) are normally open; 3. All economic systems are open systems; 4. A change at initial conditions does not lead to similar change at the end; 5. A quantitative change in the initial condition rarely turns to same change at the end; 6. Chaos, combined with uncertainty, is a weapon of mass destruction; 7. Credit Default Swaps (i.e., financial derivatives) are the quintessential example of chaos in practice!!
CONCLUDING REMARKS This Crisis is both unique and universal: UNIQUENESS: Its concrete circumstance in which it had come to realization; UNIVERSALITY: Its general pattern of symptoms, such credit crunch, adaptive expectation, and transmission. First Full-fledged economic crisis of the present epoch of
Globalization Subjective elements vs. objective structure