Tuesday, March 29, 2016
The Seeds of Revolt
James K. Galbraith, economist son of legendary Canadian-born economist, John Kenneth Galbraith explores the rise of a nation running on fraud in service to what he calls the "looter class" excerpted here from his book, "The End of Normal."
As the criminologist William K. Black has noted, it is logically impossible for the events leading to the great crisis [the global meltdown of 2008] not to have been based on fraud. The underlying activity was, after all, loans for housing. But by the mid-1990s, housing in the United States was a mature industry, having been backed and supported by government policy since the New Deal. Home ownership rates were already very high. There was no chance of rapid growth in the sector based on the standards for credit and underwriting previously considered acceptable. The only way for the sector to grow rapidly was to relax those standards. That necessarily meant seeking out borrowers who did not qualify previously, even while financial innovation made available the funds with which to make the loans. The market for good loans was saturated. But the market for bad loans (the market for loans that will not be repaid) is effectively infinite - by definition, it is limited only by financial imagination, and by the restrictions, or lack of them, imposed by law and supervision.
Black's 2005 study of the savings and loan crisis of the 1980s and his concept of control fraud - fraud committed on organizations by those who control them - is a key reference in building the problem of crime into the study of organizations. The theory of control fraud holds that organizations are most vulnerable to being taken down from the top, through devices that transfer funds to the persons who are in control. This can be done in many ways, from the simple device of overpaying top executives to more occult mechanisms that can handle larger sums. Left unchecked, control fraud grows to the point where the self-dealing exceeds the amount that the corporation can extract from its environment. At this point, the organization is no longer a going concern; it exists thanks only to false accounting and is doomed to collapse when this is exposed. This is a critical conclusion of Black's analysis; control frauds always fail in the end.
...In financial firms, the temptation to loot must be ever present. The firm itself consists of nothing more than the manipulation of money and the exploitation of trust. Financial fraud consists of knowingly making contracts that cannot be honored [credit default swaps?], and representing them either as the legitimate securities of a going concern or as speculations based on reasonable risks and undertaken honestly. ...It's all about money. Controls and checks and balances are essential. Weakening or corrupting controls, both internally and by external regulation and supervision, leads toward disaster.
...When should one close a bank and indict the bankers? Is it sometimes better to turn a blind eye, to enjoy the added activity and to hope that the problem of fraud not yet detected is not too bad?
These issues surface repeatedly in the emerging history of the  crisis.. ..there was full recognition within government of pervasive financial fraud and an intense struggle over what to do about it. The struggle was won by the do-nothing faction, headed by the Treasury Department, the Federal Reserve, the Securities and Exchange Commission, and the Department of Justice, and lost by the leadership of the Federal Deposit Insurance Corporation and the office of the Special Inspector General for the Troubled Asset Relief Program [TARP].
...It is worth remembering that the resolution of the savings and loan scandal saw more than a thousand industry insiders indicted, prosecuted, convicted, and imprisoned. So far the workout of the  Great Crisis, the comparable number of senior bankers most responsible indicted is: zero.
Given the facts of the case, this raises yet another question of responsibility. To what extent did the government deliberately foster the frauds that destroyed the financial system? And if it did so, why did it do so at this particular time? Did economic conditions make tolerance for fraud a more attractive strategy in the 2000s than it was, say, in the late 1980s when the savings and loans were cleaned up? Is the government itself subject to a Minsky-Black dynamic, under which successful regulation leads to deregulation, and deregulation leads to disaster?
My argument is that fraud took over the financial system because it was expedient to allow it. And it became expedient because the relatively new stresses on the system - on a system that had, up until the 1970s, provided the foundation for sustained and stable economic growth.
When resources to fuel economic growth are abundant, fraudulent activities are not generally tolerated. There are opportunities for "honest profit" and those pursuing such profits work to control the system, which means they favor enforcement of laws against cheats and chiselers. However, when resources become scarce or expensive, opportunities for large profits for honest business are few. If the expected rate of profit - the rate that financial markets insist on as a condition for providing loans - nevertheless remains high, then fraud becomes a main channel to profitability, and fraudulent activities become part of standard practice. Fraud is a response, in short, to the failure of lenders to adjust to a decline in real possibilities. This was the pattern in the information technology ["dot.com"] boom, where ultimately the scarce resource was a "viable business plan."
...In short, the United States, and the world over which it effectively ruled, enjoyed a quarter century of postwar expansion because of stable governing institutions, cheap resources, the military security provided by nuclear stalemate in the Cold War, and high confidence in future prospects, bolstered - in a minor way, but nevertheless - by the academic construct of the theory of economic growth. ...While the good times lasted, honest business could make decent profits, and there was, from every political economy standpoint, a powerful politics behind strong regulation and strict standards. Fraud was present in the era of the great corporation in the 1950s and 1960s, but it could not become dominant because the larger polity saw no interest in tolerating it.
Beginning in the 1970s, the conditions for sustained profitability eroded. Rising import and resource costs were emerging difficulties, even as the success of the previous years had made sustained and even increasing profitability a mental habit and a benchmark for business success. There was an inherent conflict between what was objectively possible and what was conventionally expected. Something would have to give. It would not be the expectation.
In the 1980s, resource costs were again beaten down and confidence was restored, but this time at a fearful price in the rest of the world. The global rise in inequality seen during that decade is proof that growth could no longer be shared. And the enduring governance innovation of the 1980s was deregulation: a device openly intended to reduce "burdens on business" and raise its capacity to earn profits at the expense of workers, customers, taxpayers, and honest competition. In the financial sector, specifically in the savings and loan industry, it became clear quite quickly what this meant in practice. The withdrawal of supervision opened the door to industry-wrecking financial frauds, which were ultimately recognized and beaten back, but only at great cost.
So [following the dot.com bubble of the 1990s] we moved to the 2000s, with rising resource costs once again, the depressing aftermath of the information technology bust, and (as the decade progressed) the realization that military superiority no longer brought enduring economic benefits. And yet the expectation of steady growth and high profitability still remained, powerfully embedded in the national psyche. No president could afford simply to walk away from that responsibility - and especially not one with as little political legitimacy as George w. Bush. In this environment, financial fraud was not merely an incidental feature. It was the solution to a political problem.
Whether President Bush and his associates understood this is a question for historians to investigate, if they can. ...George w. Bush's problem was that he was out of good options and had to fall back on a set of rogue institutions, from the mortgage originators to the commercial and investment banks - exploiting the world's belief that the American household sector was a sound borrower, when, in fact the recipients of the new lending at the margins were not sound at all. Exactly as in Russia in the late phase of the Soviet Union and thereafter, the response to those in charge of the strategic enterprises (in our case, banks) to the opportunity they had was to loot them for all they were worth. and so the economy stumbled forward until it could no longer do so, and then all hell broke loose.
The implication is that the collapse is definitive. That it was not followed by a normal business cycle upturn on the model of postwar normality should not come as a surprise. We are at the end of the postwar period and those models no longer apply. Moreover, it cannot be cured by the application of Keynesian stimulus, along the lines urged by many of my fellow-Keynesian friends. The institutional, infrastructure, resource basis, and psychological foundation for a Keynesian revival no longer exist. The car does not have magneto trouble. Due in part to the regulatory neglect - the failure to put water in the radiator and oil in the crankcase - it has suffered a transmission failure. A meltdown.
More gas in the engine will not make it go.