There is much discussion today at least in liberal circles, as to whether and when a new version of Glass/Steagall, separating the plain vanilla world of commercial banking from the speculative investment banks. Important as that issues is, it is equally important to assess the forces that broke down this wall. Bankers’ greed, though always amply present, will not constitute an adequate answer.
These smooth divisions faced major challenges in the stagflation era, and bankers’ responses cannot be characterized simply as greed. Depository institutions began losing customers to money market mutual funds, funds that invested in short term government and corporate bonds and paid a higher rate of interest than regulated banks were allowed to pay. And they also lost revenue sources on the loan side as many corporations started financing their own expansion through offerings of bonds on an emerging “corporate paper”market.
Even the most well run and conscientious depository institution faced a problem. It is easy to criticize the repeal of Glass/Steagall and criticism is warranted. But for a regulatory regime to have persisted it would need to have become attentive to changes in the nation’s total financial infrastructure, including regulation of the money market mutual funds and the stock market as well.
Why was the response to the increasing competitive difficulties of depository institutions to allow them to merge with investment banks and compete in financial markets? History doesn’t follow any sure arc, but in the general climate of the period, with its growing faith in deregulation in all domains of economic life, the exponents of bank deregulation were playing on favorable turf. And the academy cooperated by developing a theory that extended classical economics’ celebration of labor and product markets to finance as well. Eugene Fama’s Efficient Market Hypothesis asserted that “all information relevant to the correct pricing of securities is utilized in the pricing process.” The market in finance is assumed to be perfect.
Though the hypothesis has been subject to such telling critiques as the counter that all parties to a transaction generally do not have equal access to information, there are other deeper critiques that go to the heart of the issues separating Keynes from neo classical economics. U Mass economist James Crotty points out that theories of perfect financial markets make a number of extraordinary assumptions. They assume agents are rational, and by rational they mean that all agents know the statistical distribution of future cash flows with certainty. They also assume that prices are always in equilibrium, there are no liquidity problems, i.e. one can always find a buyer for any security. Agents are also taken not to become more optimistic in a boom and more pessimistic in a recession or depression. The positive feedback loops that are the bane of any science positing full predictability are simply assumed out of existence.
Many of these financial market theorists know and acknowledge that such assumptions are absurd. They maintain, however, that unrealistic assumptions are permissible as long as the empirical predictions to which they lead are sound. Yet as Crotty points out, with computer simulations today economists can run millions of correlations involving aspects of the theory and find some that work. Efficient market theory is little more than a desperate effort to confirm a perfectly predictable world of finance and reap the benefits from lax regulation of that realm. The simplistic assumption of complete rationality, which really means ability to prophesy the future, is not only hard to sustain, it also has been associated with empirical results that at best show weak correlations and with failure not only to predict but even have any capacity to explain the world financial crisis.
Modern post-Keynesians, those who wish to save Keynes from both his American bastardization and his finance industry critics, also begin with a set of assumptions. Unlike their opponents’ assumptions, however, these are radically different. They are also presented with full willingness not merely to assess the empirical findings they generate but also to debate their realism.
Post Keynesians maintain that the future is inherently unknowable. It is characterized by uncertainty rather than calculable risk. Thus to use an example Keynes cited, the chances of war breaking out in Europe is qualitatively different from computing the likelihood I will roll a 12 in a game of dice. In the former case outcomes are not confined to a known finite set of possibilities. In such perplexing situations all investors can do is extrapolate from recent circumstances. During an economic upswing investors will make modest investments. The longer they are successful the greater their confidence, and buying securities once seen as risky will appear prudent.
Banks play a major role in this process. In the deregulatory era banks were far more than intermediaries waiting for deposits before they made loans. These banks made loans and then went looking for reserves. They created complex derivatives that allowed them to expand. As they grew their capital costs decreased as investors surmised they would be deemed too big to fail. Thus expectations are pro-cyclical, becoming more optimistic in booms and more pessimistic in downturns and wildly unstable in panics.
Some post Keynesians bring neuropsychology and the complexity of mind body interactions into discussions of the inherent unpredictability of these financial realms.
Many post Keynesian and institutional economists can correctly maintain that unlike their colleagues they warned of the possibility of financial crisis well before its onset. There are times and domains that display relative predictability. In addition one can build dynamic models that take into account uncertainty and unpredictability. Dynamic models of hurricanes developed by meteorologists elucidate the range of possibilities and thus can indicate areas of coastline that will not be hit.
The assumptions of the post Keynesians are not a slam dunk, but their advocates do not cop out with the claim that they need not be debated as long as their empirical results are sustained. They would argue that they can establish very good correlation models, that many of its practitioners pointed to the possibility of crisis. Steve Keen’s work correlating changes in the rate of debt creation with GNP seems especially promising. They also argue that there are good historical and behavioral studies that help sustain their assumptions. To avoid a future crisis — and to pull ourselves out of this one—will require more than a socially responsible academic community, but scholarship has an important role to play.
John Buell writes on labor and environmental issues. Email email@example.com.
From The Progressive Populist, January 1-15, 2014
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