Reflections on a Global Financial Crisis (Critical Perspectives on International Business)

Editorial

Article Type: Editorial From: critical perspectives on international business, Volume 5, Issue1/2

As Critical Perspectives on International Business prepared to enter its fifth year of publication, we found ourselvesfaced with a situation which was considered by some as the major crisis of the twenty-first century – global financialmeltdown. In September 2008, the possible consequences of this crisis overshadowed concerns about climate change,AIDS and terrorism in the media – or, at least, in the Anglo-American media. In response to the problem, UK academicStefano Harney was reported in the Times Higher Education Supplement (Corbyn, 2008) as blaming businessacademics for contributing to the origins of this crisis through ignoring social and political questions in their teaching –the very questions that CPoIB has sought to address.

In order to contribute to the debate at an early date, CPoIB sent out a call for short, critically reflective papers whichwould be subject only to editorial review, so that they might appear as quickly as possible and stimulate furtheracademic debate. In response to the call, we received a substantial number of submissions from across the world,engaging both with theoretical issues and empirical examples. We have selected the best of these papers for inclusionin this double Special Issue in order to provide the broadest range of critical and stimulating inputs to the debate.

We set the scene with David Weitzner and James Darroch’s paper on “Why moral failures precede financial crises”.This leads into a series of theoretical discussions from: Giorgos Kallis, Joan Martinez-Alier and Richard B. Norgaard;Suhaib Riaz; Roy E. Allen and Donald Snyder; and Loong Wong. These papers approach the issue from a range oftheoretical perspectives, including institutional theory, systems theory, and political and economic theory. FedericoCaprotti’s paper ponders the future role of the state in relation to financial frameworks and leads into the group ofempirical studies by: William V. Rapp; Manuel B. Aalbers; Arvind K. Jain; Jon Cloke; Robin Klimecki and Hugh Willmott;and André Filipe Zago de Azevedo and Paulo Renato Soares Terra. These papers present critical analysis of a varietyof financial institutions in the USA, the UK and Brazil. We end the Special Issue with Steven Pressman’s call for a returnto the economics of Keynes and Jan Toporowski’s short reflection on the implications of the financial crisis for the fieldof international business.

We hope that this collection will stimulate further discussion in the academic literature, will be found of relevance tothose engaged in determining future financial institutional frameworks and practices, and will inform the types of criticalmanagement education called for by Stefano Harney.

References

Corbyn, Z. (2008), “Did poor teaching lead to crash?”, Times Higher Education Supplement, 25 September, available

at www.timeshighereducation.co.uk/story.asp?storycode=403696 (accessed 29 September 2008)

George Cairns, Joanne Roberts

Editorial file:///E:/%E7%94%B5%E5%AD%90%E5%9B%BE%E4%B9%A66/Editori...

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Why moral failures precedefinancial crises

David Weitzner and James DarrochSchulich School of Business, York University, Toronto, Canada

Abstract

Purpose – This paper aims to explore the linkages between greed and governance failures in bothfinancial institutions and financial markets.

Design/methodology/approach – The paper described how innovation changed the US financialsystem through an analysis of recent events, and employs the philosophic concepts of hubris andgreed to explain certain developments.

Findings – The development of the shadow banking system and opaque products was motivated inpart by greed. These developments made governance at both the institutional and market levelsextremely difficult, if not impossible. In part the findings are limited by the current opacity of themarkets and the dynamics of events.

Practical implications – The implication of the research is to reinforce the need for transparency ifthe risk of innovation in the financial system is to be both identified and managed. The creation ofcentral clearing houses and/or exchanges for new products is clearly indicated.

Originality/value – Understanding the linkages between greed, hubris and governance in thedevelopment of opaque products provides insights of value to those trying to understand the currentcrisis – from academics to practitioners.

Keywords Governance, Ethics, Financial markets, Banking, United States of America

Paper type Conceptual paper

IntroductionInnovation and crises are endemic to the financial system and while every failure leadsto significant regulatory improvement, it has never been enough to prevent the nextfinancial crisis (see, for example, Laeven and Valencia, 2008; Rowe and Day, 2007). Yet,each crisis has unique elements and the current crisis cannot be understood withoutseeing how financial innovation fundamentally changed the financial system of theUSA and consequently for those financial systems connected to the USA – essentiallythe globe. To this end, it is important to note that the drivers of the problems –structured finance products – were essentially creatures of the unregulated or lightlyregulated side of the US financial system, where greed was unchecked (Johnson andNeave, 2008). While there was clearly a failure of regulation, it should be first seen as afailure in scope of regulation. But it is equally important to understand how hubrisunited with greed was instrumental in players working to create an unregulatedmarket. What is stunning about the current crisis is that it is the result of governancefailures of both the boards of financial institutions and markets despite significantregulatory reforms in the banking world – Basel II – and corporate governance in theUSA – Sarbanes-Oxley (SOX). The lesson to be learned is that regulatory reformwithout ethical reform will never be enough.

The faith that public policymakers had resolved the major economic issuesassociated with business cycles and volatility combined with the private sector’s faithin hyper-rational modern finance and unregulated markets (Lynch, 2007) created an

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critical perspectives on internationalbusinessVol. 5 No. 1/2, 2009pp. 6-13q Emerald Group Publishing Limited1742-2043DOI 10.1108/17422040910938640

environment conducive to the growth of greed. The arrogant faith in the new financialorder led to a lack of attention to governance and ethics despite famous ethical failuresand heightened regulatory concerns. While it is often said that success breeds success,long bull markets and excess liquidity breed over-confidence and an over-commitmentto revenue-generating activities as opposed to control activities. In this environment ofweak governance, unethical behavior flourishes. Management scholars have alreadyfaced tough questions about the ethical implications of their theoretical suppositions(Ghoshal, 2005), but the current financial woes have led to renewed calls for a morecentral place for ethical considerations in mainstream management theories along withnew questions about the significant role greed and hubris tend to play in the practice ofmanagement. We believe that the time has come for researchers concerned with thefinancial system and the question of ethics to address explicitly the problem of greed.

“The Great Moderation”: hubris and the limits of rationalityThere was a belief that policymakers had created a new and less volatile world. BenBernanke in a 2004 speech talked about the new world of the “Great Moderation”:

The Great Moderation, the substantial decline in macroeconomic volatility over the pasttwenty years, is a striking economic development. Whether the dominant cause of the GreatModeration is structural change, improved monetary policy, or simply good luck is animportant question about which no consensus has yet formed. I have argued today thatimproved monetary policy has likely made an important contribution not only to the reducedvolatility of inflation (which is not particularly controversial) but to the reduced volatility ofoutput as well. Moreover, because a change in the monetary policy regime has pervasiveeffects, I have suggested that some of the effects of improved monetary policies may havebeen misidentified as exogenous changes in economic structure or in the distribution ofeconomic shocks. This conclusion on my part makes me optimistic for the future, because Iam confident that monetary policymakers will not forget the lessons of the 1970s (Bernanke,2004).

Unfortunately, the policymakers were not alone in their heightened self-confidenceconcerning their ability to manage the economy. The massive egos of many leaders,executives and aspiring executives of financial firms also played a role. The popularpress abounds with stories of the arrogance of players in the financial world, both realand fictional (Bruck, 1989; Lewis, 1989; Stewart, 1992; Wolfe, 1987). Much of thearrogance is brought about by a blind faith in modern finance and perhaps thelikelihood of government intervention if things went wrong. This may have been thelesson drawn by market participants from the 1998 crisis brought about by the hedgefund Long Term Capital Management (LTCM). Despite mounting evidence, the playersat LTCM clung to the belief that their models were correct and that what washappening to them could not happen to them (see, for example, Lowenstein, 2000). Butat the darkest moment, the Fed intervened, brought together the players, and found aresolution.

Nassim Nicholas Taleb’s attacks on the unfounded belief in the new “pseudoscience” in Fooled by Randomness (Taleb, 2005), The Black Swan (Taleb, 2007a) and theFinancial Times (Taleb, 2007b) clearly demonstrate the need for humility, as well as artin risk management. There can be little doubt but that arrogance led many strictlyquantitative financiers to underestimate dramatically the events that were unfolding infront of them. A blind faith in technical mastery of complex financial models left many

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financial professionals so enamored with probability that they forgot about theuncertainty that was in the tail of their distributions. Perhaps one striking event in thecurrent crisis will turn attention from computer screens to reality:

The turmoil in financial markets has taken hold of the strategically important trade inlong-term interest rate derivative, pushing rates to levels once thought to be a “mathematicalimpossibility.”[. . .]

On Thursday [October 22], the 30-year swap spread turned negative after briefly flirtingwith such levels earlier in the month. This implies that investors are somehow reckoning thatthey are more likely to be paid back by a private counterparty than by the government, whichcan print money (Mackenzie, 2008).

The arrogance born out of a belief in hyper-rational “scientific” models is especiallystriking given the recognition that modern economics has given to the field ofbehavioral economics and finance. The Nobel Prize in economics surely conferredintellectual respectability upon the field when it awarded the prize in economics toGeorge A. Akerlof, A. Michael Spence, and Joseph E. Stiglitz for their analyses ofmarkets with asymmetric information in 2001, followed in 2002 with the award toDaniel Kahneman for his seminal work on psychology and economics and VernonL. Smith for having legitimized laboratory experiments in the field of economics. Theevidence was there for all to see that hyper-rationalistic models needed to be appliedwith caution.

The evidence was not only there in theory but in past experience. In remarksconcerning the LTCM failure and the Asian Crisis, Federal Reserve Governor LaurenceH. Meyer (1999) noted that the correlations among markets behaved differently thanexpected by the market strategists. The correlation among the markets increased, andconsequently heightened rather than lessened the impact of events. The belief in therandom behavior of markets blinded market participants to the possibility of systemicissues tied to herd behavior. Yet, in 1841, Charles MacKay published ExtraordinaryPopular Delusions and the Madness of Crowds about earlier financial crises (MacKay,1841). Greed has the power to transform random events into herd behavior.

What is greed?We now need to explore the concept of “greed” and why it is considered by many in oursociety to represent a less than virtuous trait (notwithstanding the fact that the “greedis good” mantra, popularized by Oliver Stone’s “Wall Street”, has been adopted withoutirony by some in the business profession). “Greed” is in essence a rather difficultconcept that has engaged thinkers across all religious and philosophical traditionsthroughout history. In Western society, it is perhaps most notably associated with theseven deadly sins of the Christian faith, but Tickle (2004) notes Hindu, Buddhist,Taoist, Sikh, Muslim and Jewish sources which supports her assertion that everysystem has explored greed and all its “aliases” including (but not limited to)acquisitiveness, covetousness, avidity, cupidity, avarice, miserliness and simony.Tamari (1997) identifies greed as one of the two main sources of economic immoralityand explains how traditional Judaism limits the harmful effects of greed through adivinely revealed code that provides a normative economic morality. In the Jewishtradition, economic activity and the acquisition of wealth can be viewed as virtuous

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undertakings, depending on the source and the purpose of the activity. In this light,business is good, economic growth is good, but greed is not.

Yet one does not need to refer only to classic religious traditions to find anintellectual and moral disdain for greed in all of its manifestations. Bragues (2006) hasrecently reminded business ethics scholars of the potential for Aristotelian virtue toinform our current debate on the place for greed in the practice of business. Generosityand magnificence are two virtues discussed by Aristotle and reinterpreted by Bragues(2006) that encourage morally minded individuals to pursue capitalist interests andeven enjoy the fruits of acquired wealth without sliding into the vice of greed.Magnanimity as a business virtue in Bragues (2006) is illustrated by an individualmanager who is not motivated primarily by the pursuit of wealth, but by nobler goals.In a similar Aristotelian spirit, Solomon (1993) explains that in opposition to a vice likegreed, virtues represent the best in us and our communities, and the drive to excel forreasons that go beyond the simple pursuit of profit represents the most elementary ofvirtues appropriate to the discipline of management.

For this paper, we wish to propose a working definition of greed that is rooted ineconomic behavior while embracing a moderate position closest in spirit to the Jewishand Aristotelian traditions that view greed as a vice only to the extent that it serves tohamper the positive possibilities of economic exchange. We propose that greed in thiscontext needs to be viewed as occurring in situations where an individual seeks aneconomic return of greater value that what her input should reasonably earn and in sodoing imposes costs upon others. The other is harmed in this process because theother’s ability to claim fair value is oppressed. In the context of the firm operating insociety, greed is encountered when a firm attempts to avoid paying the full costs for itsbehavior (what economists call externalities). The pursuit of economic rents cantherefore be virtuous provided that the economic actors respect the notion of mutuallybeneficial exchange as the ethical core of economic activity.

Virtuous management involves a delicate balancing act between seeking out anddeveloping innovative techniques and behaviors while at the same time keeping theseinnovations in check to ensure that they are conforming to society’s norms of ethicalbehavior. Financial innovations in particular can bring about significant and tangiblesocial good in spurring economic innovation. For example, innovations in the financialmarkets have resulted in popular mechanisms that allow for houses to be made moreaffordable to the average family. However, these same financial innovations that offeropportunity for the average individual also have the capacity to tempt investors intoirresponsible behavior motivated by greed and the potential of unusually high returns.Perhaps no financial innovation demonstrates this more clearly than derivatives,which allow individuals and firms to limit their exposures to undesirable outcomes orto gamble recklessly in the pursuit of high returns. In an ethical sense, financialinnovation increases our opportunities to act as prudent, caring individuals, limitingharm to stakeholders such as employees, customers, and shareholders. But derivativesalso create the opportunity to gamble on a massive scale.

What this means is that even if the financial innovations are ethically neutral, theactions of the economic actors employing these innovations are not. If we cannot or donot wish to limit financial innovation then we must be fundamentally concerned aboutthe moral character of those in the vanguard of poorly understood innovations. Whileeconomists and regulators may focus on the knowledge problem, it is just as importantto look closely at the moral character of the players because financial innovation

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creates new structural conditions with the possibility of doing both good and ill. In thiscontext it may be useful to recall the desire expressed in the Lord’s Prayer: “Lead us notinto temptation”. It is critical for management scholars concerned about ethics tounderstand the implications of the structural changes in the financial sector and tofurther understand that in many cases the only safeguard is the moral character of thefinanciers.

The new world of banking: “the shadow banking system”While greed is a constant in human behavior it is important to recognize how thefinancial world changed and created new opportunities for avarice that had systemicimplications. William R. White (2004) at the Bank for International Settlement haswritten of the phenomena of “marketization”: the growing importance of financialmarkets compared to traditional financial institutions (e.g. banks). We need to realizethe radical shift that has taken place in financial systems concerning credit facilitiesand risk transfer. The primary source of debt for firms has become the markets – orthe “shadow banking system” as it has become known, and this has transformed theworld of credit risk management (Rowe and Day, 2007). Moreover it is outside of USregulation. Christopher Cox, Chairman of the SEC, testifying to the Senate BankingCommittee on September 23, 2008, made clear the role of lack of regulation in thecurrent financial crisis:

The failure of the Gramm-Leach-Bliley Act to give regulatory authority over investment bankholding companies to any agency of government was, based on the experience of the lastseveral months, a costly mistake. There is another similar regulatory hole that must beimmediately addressed to avoid similar consequences. The $58 trillion notional market incredit default swaps — double the amount outstanding in 2006 — is regulated by no one.Neither the SEC nor any regulator has authority over the CDS market, even to requireminimal disclosure to the market (see www.sec.gov/news/testimony/2008/ts092308cc.htm).

Former Federal Reserve Chairman Alan Greenspan, testifying before the HouseCommittee of Government Oversight and Reform, confessed that he had counted uponthe self-interest of financial institutions to protect shareholder equity. It should benoted that such a faith in market governance was not without support. The failure ofthe hedge fund Amaranth in September 2006 was in many ways a precursor to thecurrent wave of financial failures, yet it caused no such systemic problems. Amaranthwas trading futures on an organized exchange where the exchange was thecounter-party to Amaranth’s contracts. As Amaranth started to get in trouble, theexchange forced the sale of Amaranth’s contracts in a liquid market to maintain itsmargin position (Cecchetti, 2007). As a result of these forced sales, while Amaranthfailed and its shareholders lost, there were no systemic problems. The exchange hadthe information and ensured that market governance worked. In governance terms,Amaranth’s transactions were transparent to market participants. Such is not the casewith many of the innovations in what has come to be called the “shadow bankingsystem”:

A plethora of opaque institutions and vehicles have sprung up in American and Europeanmarkets this decade, and they have come to play an important role in providing credit acrossthe financial system. Until the summer, structured investment vehicles (SIVs) andcollateralised debt obligations (CDOs) attracted little attention outside specialist financialcircles. Though often affiliated to major banks, they were not always fully recognised on

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balance sheets. These institutions, moreover, have never been part of the “official” bankingsystem”: they are unable, for example, to participate in today’s Fed auction.

But as the credit crisis enters its fifth month, it has become clear that one of the key causesof the turmoil is that parts of this hidden world are imploding. This in turn is creating hugeinstability for “real” banks – not least because regulators and bankers alike have been badlywrong-footed by the degree to which the two are entwined.

“What we are witnessing is essentially the breakdown of our modern-day banking system,a complex of leveraged lending [that is] so hard to understand”, Bill Gross, head of Pimcoasset management group recently wrote. “Colleagues call it the ‘shadow banking system’because it has lain hidden for years, untouched by regulation yet free to magically andmystically create and then package subprime loans in [ways] that only Wall Street wizardscould explain.” (Tett and Davies, 2007).

We wish to call attention to one particular aspect of this “unregulated” market: itsopaqueness. The market for credit default swaps is essentially an over-the-counter(OTC) market with bilateral contracts between buyer and seller. In this market, there isno one monitoring all positions and enforcing margin requirements that act as a buffer.It must be recognized that the opaqueness of the market reflects a strategic choice bythe participants. Participants could have chosen to create from the start the clearinghouses and even exchanges that they are now considering (The Economist, 2008; Tettet al., 2008). This would have made this market far more transparent. Yet, ignoring thepotential risks of opaque markets, the participants opted for opacity. The opacitymeant that even market participants were functioning in a world where the lack ofinformation made it impossible to assess accurately the full credit risk ofcounter-parties and there was no mechanism to buffer mistakes.

The merger of the Chicago Mercantile Exchange (CME) and the Chicago Board ofTrade (CBOT) hoped to challenge the OTC markets and become the clearing house forall on-exchange derivatives and move into the OTC market with its own products. Notsurprisingly this has met with the opposition of major banks, which control 85 percentof global derivatives trade (Cameron, 2007). The response of the banks was to beexpected – all firms seek to protect their profitability – but in this case, the greed forprivate profits led to extremely high public costs. Greed overrode considerations ofcreating the appropriate infrastructure of information disclosure necessary to ensuremarket governance. Interestingly, if market governance couldn’t work, neither couldfirm governance, since there was inadequate information on the positions taken byindividual players. It should further be recognized that the many of the problems in thesubprime mortgage market were also tied to improper governance related to lowerlevels of screening for securitized products (Keys et al., 2008).

ConclusionThe blind faith in markets being able to count upon self-interest to ensureself-regulation ignored major advances in the field or economics. Self-interest may wellhave guided actions but it was the form of self-interest which is at the heart of agencyproblems. It seems reasonably clear that while the shareholders were wiped out, manyplayers at the institutions were considerably enriched during the process – even withgolden parachutes. While there may be problems in implementing controls onexecutive compensation, it is hard not to believe that devastated shareholders areentitled to a certain level of righteous indignation. We believe that it is correct tobelieve that self-interest spelt greed can be counted upon – but it can be counted upon

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in just the way that agency theorists fear. Greenspan’s comments only serve todemonstrate how isolated insiders of the financial community had become to broaderconcerns.

The “shadow banking system” was a governance failure waiting to happen. First,how could the governance structures at firms such as Lehman have measured theirexposure to credit risk given the lack of information decried by Cox? Clearly the boardsof the banks were not performing the oversight role that they owed to theirshareholders. The failure of many institutions has once again revealed the governanceproblems that both SOX and Basel II sought to correct. The decision to opt for opaquemarkets was a strategic decision with serious consequences. Secondly, free marketadvocates must recognize that in order for free markets to function, there must be opendisclosure of information. Market governance is impossible in the absence of relevantinformation.

The immediate challenge is to restore trust not only among financial institutions torestore the inter-bank markets, but also trust from the public. This is a tall order. Greedled to the governance failures at both the market and individual institutional level.Financial players who should have been committed to the good of the system in orderto ensure that they could create wealth for themselves while improving the lot of othersfailed to recognize this obligation. Rather, greed and hubris led to the enrichment of thefew to the cost of the many. It would be naive to believe that a moral renaissance is athand and will solve all ills, so until that time we must enforce rules to promote thevirtue of transparency to prevent shadow worlds in the financial system.

References

Bernanke, B.S. (2004), “The great moderation”, remarks at the meetings of the Eastern EconomicAssociation, Washington, DC, February 20, available at: www.federalreserve.gov/BOARDDOCS/SPEECHES/2004/20040220/default.htm

Bragues, G. (2006), “Seek the good life, not money: the Aristotelian approach to business ethics”,Journal of Business Ethics, Vol. 67, pp. 341-57.

Bruck, C. (1989), The Predators’ Ball: The Inside Story of Drexel Burnham and the Rise of the JunkBond Raiders, Penguin, New York, NY.

Cameron, D. (2007), “CME accuses banks of inflated profits”, Financial Times, March 13.

Cecchetti, S. (2007), “A better way to organise securities markets”, Financial Times, October 4.

(The) Economist (2008), “Derivatives: clearing the fog”, The Economist, April 17.

Ghoshal, S. (2005), “Bad management theories are destroying good management practice”,Academy of Management Learning and Education, Vol. 4, pp. 75-91.

Johnson, L.D. and Neave, E.H. (2008), “The subprime mortgage market: familiar lessons in a newcontext”, Management Research News, Vol. 31 No. 1, pp. 12-26.

Keys, B.J., Mukherjee, T., Seru, A. and Vig, V. (2008), “Securitization and screening: evidencefrom subprime mortgage backed securities”, EFA 2008 Meeting, Athens, available at:http://papers.ssrn.com/sol3/papers.cfm?abstract_id ¼ 1093137

Laeven, L. and Valencia, F. (2008), “Systemic banking crises: a new database”, Working PaperNo. WP/08/224, International Monetary Fund, Washington, DC.

Lewis, M.M. (1989), Liar’s Poker: Rising through the Wreckage on Wall Street, W.W. Norton, NewYork, NY.

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Lowenstein, R. (2000), When Genius Failed: The Rise and Fall of Long-Term CapitalManagement, Random House, New York, NY.

Lynch, J.T. (2007), “Credit derivatives: industry initiative supplants need for direct regulatoryintervention: a model for the future of US regulation?”, March 8, available at: http://ssrn.com/abstract ¼ 975244

MacKay, C. (1841), Extraordinary Popular Delusions and the Madness of Crowds, WilderEditions, Harmony Books, New York, NY.

Mackenzie, M. (2008), “Credit crunch upsets 30-year rate swaps”, Financial Times, October 23.

Meyer, L.H. (1999), remarks before the International Finance Conference, Federal Reserve Bankof Chicago, Chicago, IL, October 1.

Rowe, D.M. and Day, T. (2007), “Credit risk management’s 25 year transformation”, The RMAJournal, October, pp. 39-44.

Solomon, R.C. (1993), Ethics and Excellence, Oxford University Press, New York, NY.

Stewart, J.B. (1992), Den of Thieves, Simon & Schuster, New York, NY.

Taleb, N.N. (2005), Fooled by Randomness, 2nd ed., Random House, New York, NY.

Taleb, N.N. (2007a), The Black Swan: The Impact of the Highly Improbable, Random House,New York, NY.

Taleb, N.N. (2007b), “The pseudo-science hurting markets”, Financial Times, October 23.

Tamari, M. (1997), “The challenge of wealth: Jewish business ethics”, Business Ethics Quarterly,Vol. 7, pp. 45-56.

Tett, G. and Davies, P.J. (2007), “Out of the shadows: how banking’s secret system broke down”,Financial Times, December 17.

Tett, G., Davies, P.G. and Van Duyn, A. (2008), “A new formula? Complex finance contemplatesa more fettered future”, Financial Times, September 30.

Tickle, P.A. (2004), Greed: The Seven Deadly Sins, Oxford University Press, Oxford andNew York, NY.

White, W.R. (2004), “Are changes in financial structure extending safety nets?”, BIS WorkingPaper No. 145, January, available at: http://ssrn.com/abstract ¼ 901385

Wolfe, T. (1987), Bonfire of the Vanities, Farrar, Strauss & Giroux, New York, NY.

About the authorsDavid Weitzner is a Sessional Assistant Professor of Strategic Management at the SchulichSchool of Business and Associate Director of the School’s Strategy Field Study Program. Hismajor research interest is in exploring the relationship between strategic activities and ethicalvirtues.

James Darroch is an Associate Professor of Strategic Management at the Schulich School ofBusiness and Director of the School’s Financial Services Program. His major research interest isthe strategic management of financial institutions with a particular focus on the relationshipbetween enterprise risk management and strategy. He has worked with several large financialinstitutions. James Darroch is the corresponding author and can be contacted at: [email protected] or [email protected]

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Paper assets, real debtsAn ecological-economic exploration of the

global economic crisis

Giorgos KallisICREA and Institut de Ciencia i Tecnologia Ambientals (ICTA),

Universitat Autonoma de Barcelona, Barcelona, Spain

Joan Martinez-AlierDepartament d’Economia i d’Historia Economica andInstitut de Ciencia i Tecnologia Ambientals (ICTA),

Universitat Autonoma de Barcelona, Barcelona, Spain, and

Richard B. NorgaardEnergy and Resources Group, University of California at Berkeley,

Berkeley, California, USA

Abstract

Purpose – This paper sets out to investigate the potential contribution of the inter-disciplinary fieldof ecological economics to the explanation of the current economic crisis. The root of the crisis is thegrowing disjuncture between the real economy of production and the paper economy of finance.

Design/methodology/approach – The authors trace the epistemological origins of this disjunctureto the myths of economism – a mix of academic, popular and political beliefs that served to explain,rationalise and perpetuate the current economic system.

Findings – The authors recommend ending with economism and developing new collective anddiscursive processes for understanding and engaging with ecological-economic systems.

Originality/value – The authors embrace the notion of sustainable de-growth: an equitable anddemocratic transition to a smaller economy with less production and consumption.

Keywords Economic depression, Recession, Ecology, Economic theory


Benjamin M. Friedman, author of The Moral Consequences of Economic Growth, recalled thatwhen he worked at Morgan Stanley in the early 1970s, the firm’s annual reports were filledwith photographs of factories and other tangible businesses. More recently, Wall Street’sannual reports tend to highlight not the businesses that firms were advising so much asfinance for the sake of finance, showing upward-sloping graphs and photographs of traders.“I have the sense that in many of these firms” Mr. Friedman said, “the activity has becomefurther and further divorced from actual economic activity.” Which might serve as asummary of how the current crisis came to pass. Wall Street traders began to believe that thevalues they had assigned to all sorts of assets were rational because, well, they had assignedthem (David Leonhardt, New York Times, 21 September 2008).

Marx long ago observed the way in which unbridled capitalism became a kind of mythology,ascribing reality, power and agency to things that had no life in themselves. [. . .] Andascribing independent reality to what you have in fact made yourself is a perfect definition ofwhat the Jewish and Christian Scriptures call idolatry (Rowan Williams, Archbishop ofCanterbury, The Spectator, 24 September 2008).



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Immediate explanations pointing to proximate causes of the current financial crisisdominate public discourse: the greedy bankers, the bad loans, the unregulated financialproducts or the collapse of the housing market. Instead, we engage with the structuralcauses of the crisis. The uneven temporal and spatial pattern of capital accumulationhas – deservedly – received much attention as a structural cause of the cyclicalrepetition of economic crises. But less attention has been paid to ecological andresource factors. This paper highlights some key ecological-economic insightsconcerning the current economic crisis. We argue that:

. at the roots of the crisis is the growing disjuncture between the real economy ofproduction and the paper economy of finance;

. the costs of the financial crisis pale in comparison to those of current andforthcoming ecological crises;

. the myths of economism – a mix of academic, popular and political beliefs thatserve to explain and rationalise the economic system – allowed and justified thedisjuncture between real and paper economies; and

. the current crisis provides opportunities at an epistemological level, to escapefrom economism and at the practical level, to promote alternative socio-economicparadigms such as de-growth and environmental justice.

But first let us explain the nature of ecological economics.

Ecological economics: bringing natural reality back into the economyThe field known as ecological economics (EE) was born out of the dissatisfaction ofeconomists and natural scientists with the treatment of environmental issues bymainstream economics. Today EE involves a diverse field of researchers united by anambition to reclaim the classical economic tradition of putting nature as a key factor ineconomic analysis. One might distinguish between a more conservative line of EEwhich accepts the basics of neoclassical economics but works to couple better economicwith ecological models and a more critical, political-economic line of research, to whichthe authors of this paper belong, which seeks new paradigms for understandingecological-economic systems as a whole and emphasises distributional, institutionaland power issues (Spash, 1999). Georgescu-Roegen’s (1971) seminal critique ofeconomics based on the laws of thermodynamics and in particular entropy and thedistinction between stocks and flows is often seen as the departure point of modern EE(though there is a long lineage of related thinking before him; see Martinez-Alier, 1990).Kenneth Boulding’s (1966) thesis on the bio-physical limitations of economic activityand Karl William Kapp’s (1970) reframing of environmental externalities as thepervasive social costs of free markets are also foundational EE contributions.

EE positions the economy as a subsystem of a larger local and global ecosystem(Daly, 1991). Ecological and economic systems are seen as mutually constitutive,metabolically related (Giampietro, 2003) and coevolving (Norgaard, 1994). EE rejectsthe rational, “homo-economicus” assumptions of mainstream economics and theirliberal-utilitarian normative counterpart, which privileges market and cost-benefitmediations of human wants. Multiple, incommensurable values are recognised anddeliberative-democratic mediation advocated (Martinez-Allier et al., 1998; Norgaard,1994). Nonetheless, many ecological economists understand also the tactical use of

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economic valuation of environmental services and negative external effects in a societywhere the generalised market is king.

EE is particularly critical of the notion of growth-as-progress (Norgaard, 1994).Gross domestic product (GDP) is criticised both technically (van den Bergh, 2006) andfundamentally as hiding the social – environmental and distributive – costs ofeconomic expansion (Martinez-Alier, 2002). From an EE perspective, externalities arenot accounting problems, but social cost-shifting successes predicated uponinstitutional and power inequalities that allow some peoples’ values to count andothers’ not (Martinez-Alier, 2002).

But how is all this relevant to the present crisis?

Real wealth versus paper wealthRather than focusing on the immediate level of finance, from an EE perspective theeconomy must be analysed at three levels. At the top there is the financial level that cangrow by loans made to the private sector or to the state, sometimes without anyassurance of repayment as in the present crisis. The financial system borrows againstthe future, on the expectation that indefinite economic growth will give the means torepay the interests and the debts. Then there is what the economists describe as thereal economy, the GDP at constant prices. When it grows, it indeed allows for payingback on some or all the debt, when it does not grow enough, debts are defaulted.Increasing the debts forces the economy to grow, up to some limits. Then, down below,underneath the economists’ real economy, there is the ecological economists’ real-realeconomy, the flows of energy and materials whose growth depends partly on economicfactors (types of markets, prices) and in part from physical and biological limits. Thereal-real economy also includes land and the capacity of humans to do work.

The EE explanation of the crisis is simple. The upper level of finance grew way toofast and too large for the real economy beneath to catch up. Frederick Soddy, a NobelPrize winner in Chemistry, had made this point in his book Wealth, Virtual Wealth andDebt (Soddy, 1926) published in 1926 (Martinez-Alier, 1990). Soddy argued that it iseasy for the financial system to increase the debts (private or public debts), and tomistake this expansion of credit for the creation of real wealth. However, in theindustrial system, growth of production and growth of consumption imply growth inthe extraction and final destruction of fossil fuels. The obligation to pay debts atcompound interest could be fulfilled by squeezing the debtors for a while. Other meansof paying the debt are either inflation (debasement of the value of money), or economicgrowth – which is falsely measured because it is based on undervalued exhaustibleresources and unvalued pollution.

According to ecological economist Herman Daly, the current crisis is due to theovergrowth of financial assets relative to the growth of real wealth; there is too muchliquidity, not too little. “Paper exchanging for paper is now 20 times greater thanexchanges of paper for real commodities” (Daly, 2008). As a consequence the value ofpresent real wealth is no longer sufficient to serve as a lien to guarantee the explodingdebt and debt is being devalued (Daly, 2008).

Can the real economy catch up with debt? Ecological economists have argued withneo-classical economists whether continuous growth is possible (see EcologicalEconomics, Vol. 22), let alone desirable. Ecological economists have scrutinised theoptimistic assumption of neo-classical economists (and most Marxists as well) that

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resource substitution and technological innovation will always surpass biophysicallimits (Daly, 1991). This is not to posit a simplistic notion of absolute bio-physicallimits to growth, but to take seriously the possibility that the depletion of stockresources, the degradation of “sinks”, such as the global atmosphere and the increasingoccupation of Earth’s space, may limit the continuous expansion of the scale of theeconomy and condition future human activity decisively (Norgaard, 1994). Adaptationto the changing environmental conditions may not be gradual or reversible: resources,sinks and ecosystems have thresholds which, once surpassed, lead to dramatic andvery fast changes. Humans may adapt to whatever the future might bring, but thequestion is how many will survive and which, at what level of subsistence they willlive, and what pain will be suffered along the way.

Bio-physical constraints and the bottom level of the economy condition the rate atwhich real wealth can increase. In addition to financing and housing, high oil pricesalso triggered the present crisis. These were due not only to the OPEC oligopoly and oilmarket speculation but also due to the approaching peak-oil (Deffeyes, 2001) andmarket expectations of it. Also while in the 1920s the price of commodities decreasedfor a few years before 1929, this time the increase in commodity prices (also driven bythe misguided subsidies to agri-fuels) continued for some months after the strongdecline in the stock exchange started in January 2008. In late 2008 the prices of oil andcommodities were declining, but this is because of declining demand, not increasingsupply. Consumption of oil is going down (Financial Times, 2008).

One could argue that oil at $US150 a barrel is in fact cheap from the point of view ofits fair inter-generational allocation and the externalities it produces. As the crisisdeepens, the price of oil goes down but it will recover in real terms if and when theeconomy grows again. Declining prices will cause some expensive sources to stopproduction (Alberta oil sands, for instance) and will also lead to lack of investment innew extraction sites. OPEC will try and reduce oil extraction during the crisis. Thescheduled OPEC meeting of mid-November 2008 was brought forward to 24 October,when it decided to cut oil extraction by 1.5 mbd. Should oil prices increase again (aidedby speculation in the futures market), then this will make economic recovery moredifficult. Peak-oil does not mean immediate scarcity. It means that it is less easy to findoil than before, and that supply cannot increase any further above the previous level.Something like half the reserves are still there, but extraction will take place at adeclining rate. We are not sure, however, whether we have already passed the peak ornot, and we cannot be certain about the economics of other energy sources. This meansthat the current rate of fossil fuel-driven growth may be unsustainable.

Even if one is not convinced that limits and peaks have been reached, the subtle factremains that there is no way the economy can grow fast enough in real terms to redeemthe massive increase in debt (Daly, 2008). As Daly (2008) argues, “spatial displacementof old stuff to make room for new stuff is increasingly costly as the world becomesmore full, and increasing inequality of distribution of income prevents most peoplefrom buying much of the new stuff – except on credit”. More crucially, with projected(desired) growth rates, the change in the global atmosphere due to greenhouse gasemissions will have such catastrophic impacts that will more than offset any growth(Intergovernmental Panel on Climate Change, 2007). Wishful thinking aboutde-materialised growth has proven elusive (Martinez-Alier, 2002; Polimeni et al., 2008).


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The real toxic debtsThe assets that take the form of claims to debts that will remain unpaid have beengiven the funny name of “toxic assets”. But what about the liabilities, like theenormous “carbon debt” that is owed to future generations, and to the poor people whohave produced little greenhouse gases (Srinivasan et al., 2008)? Large environmentalliabilities are due by private firms. Chevron-Texaco is being asked to pay back 16billion dollars in a court case in Ecuador. The Rio Tinto company left behind largeliabilities since 1888 in Andalusia where it got its name, and also in Bougainville, inNamibia, and in West Papua together with Freeport McMoran (Martinez-Alier, 2002).These are debts to poor or indigenous peoples, also like those of Shell in the NigerDelta. These real poisonous debts are in the history books but not in the accountingbooks. New fossil fuels and mineral sources have a low EROI (energy return oninvestment) and high marginal costs. Diplomatic and military pressure on theexporting countries intensifies; although the rate of oil extraction could still increasesomewhat, the coming down from the peak will be steeper and more conflictive still.

We do not need to subscribe to a dollars game to argue that in all likelihood theeconomic costs from global ecosystem degradation and climate change (MillenniumEcosystem Assessment, 2005; Intergovernmental Panel on Climate Change, 2007) willbe an order of magnitude higher than the accumulated debt that belies the presentcrisis. We should be even more concerned about forthcoming ecological crises than we– rightly – are about the present financial crisis.

Ironically, economists are advocating the same recipe for ecological problems to theone that belies the present financial crisis: commodify unpriced ecological goods andlet the free markets regulate their provision without state intervention. Karl Polanyi(1944), in The Great Transformation, saw the parallels between the deregulation ofmoney supply and the commodification of nature and the double danger these posed.Money and nature (alongside labour), he argued, are fictitious commodities, that isthings that circulate in the market as though they are commodities originally producedfor it, when clearly they are not. Like Polanyi, many ecological economists haveinsisted on the impossibility and undesirability of nature’s commodification (Vatn andBromley, 1994). But such voices are against the current: new fictitious markets, fromtrading carbon to pollution permits, water rights or payments for ecosystem services,are increasingly imagined and enacted (Kosoy, 2008). The risks of linking the valueand level of protection of ecosystem services to the ups and down of markets andcurrencies go unnoticed (Harvey, 1996; Kosoy, 2008).

To understand how these myths of self-regulating markets, perpetual growth andthe disjuncture of the fictitious, paper economy from the real economy came to be, weneed to turn to the realm of ideas and their interaction with politics and economics.

The myths of economismLet us distinguish between an economy that is “out there” and the complex of mythsthat people, both individually and in order to act together, have developed to aid themin living within the economy. This distinction is roughly parallel to nature as a realityof its own and the complex of myths traditional peoples hold about nature and theirrelation to nature. In traditional societies, myths provide explanations for naturalphenomena, facilitate individual and collective decisions, and give meaning andcoherence to life. As people act on their myths, their societies and the natural

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environment are shaped and co-evolve around them. Today, as we act on scientificunderstandings that were first mechanical, then chemical, and more recentlybiological, we see agricultural soils and rural communities transforming andco-evolving with the path of science (Norgaard, 1994). As modern people, we also act oncomparable beliefs about our world (a world that is largely economic), that are rootedin the discipline of economics. We refer to this complex of myths as economism, andlike traditional beliefs and scientific understanding, economism explains phenomena,facilitates individual and collective decisions, and gives meaning and coherence to ourlives. Similarly, our economy is driven by and coevolves around economism.

With a 25-fold increase in global market activity during the twentieth century, theeconomy became the cosmos of roughly half the world’s people. The rise of the marketeconomy in everyday life, with exchange occurring over ever greater distance, can bethought of as a wedge between our contact with nature and with the moralconsequences of the decisions we make. The growth of the economic cosmos is bothfacilitated and rationalised in public discourse by economic reasoning, albeit typicallyquite simplified. Simplification is also key to the dominant approach of rationalthinking and the nature of disciplines. The history of scholarly economic thought canbe understood as a process of boundary keeping, a process of rationalising argumentsthat either ignored entirely or entailed gross simplifications about the natural worldand broader questions of right and wrong.

Increasingly, modern people, few of whom are trained in the natural sciences, mustpeek through the economy to see how we relate to the natural world. Economists havepioneered and encouraged this approach. Barnett and Morse (1963) provide a clearexample of trying to understand the state of nature and our relation to it through theeconomy. They argued that resources could not possibly be scarce because resourceprices declined from the late nineteenth century through much of the twentieth. Risingprices indicate resource scarcity whether simply thinking in terms of supply anddemand between two periods, using Ricardo’s argument about how the best land isused first, or exploring Hotelling’s far more sophisticated model of optimal resourceuse over time. These patterns of thinking can be summarised by the simple argument:

If resources are scarce,If market participants know that they are scarce,Then resource prices will rise.

Barnett and Morse, and numerous economists and non-economists since (Simon, 1981;Lomborg, 2001) have simply reversed the argument, declaring that since resourceprices have been falling, resources cannot be scarce. But the minor premise of their ownargument, the part that connects economics to reality, has been forgotten. If marketparticipants do not know resources are scarce in some real sense, the economicargument is invalid. If they do know, we should simply ask them. Surely it is better tolearn from the differences in understanding between participants and thereby learnabout the risks and conditions under which their understandings are more likely true.Prices simply blend the complexities of their understanding to a single directionalindicator with no other information (Norgaard, 1990).

The critically important point, however, is that for markets to work well, sufficientmarket participants need to understand independently the reality behind the markets.Economists, however, are arguing that we can understand reality through markets


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apart from whether the actors in the market understand reality. This presumptionexplains how trouble arose in the USA through the housing market. Judging realitythrough the market, home buyers and banks were confident that housing prices wouldcontinue to go up because housing prices had “always” gone up. Lenders made loans tohome owners whose abilities to pay were marginal and contingent upon both a healthyeconomy and their beliefs that home prices would always rise. Lenders knew that thesenew home owners might not be able to make their mortgage payments, but this wasnot seen as a problem because the banks thought they would simply be left holding anasset whose value was still greater than the mortgage that remained to be paid. ThenWall Street investment banks repackaged the risky mortgages as equities, portrayingthem as hot stocks in a rising market. The mass deception worked, indeed theincreased perception of wealth helped drive up home prices by adding to the demandfor homes. Everything was going up until energy prices also went up and the economybegan to be less healthy. Mortgage payments were not made, banks foreclosed, but asthey did so in increasing numbers, housing prices dropped, and the assets of the banksbecame “toxic”. The problem was that all the actors in the process had been looking atwhat they thought was reality through trends in market signals rather than looking atthe underlying reality.

For the same reasons that the financial crisis arose, managing it is difficult becauseeconomic actors are looking at crashing equities prices rather than underlying realconditions, which surely have not changed that drastically, and as they do, the marketcrashes ever more rapidly in a self-fulfilling prophecy.

When we do try to assess the underlying ecological basis of our economy, thesituation looks very bleak. By a fairly simple measure, the ecological footprint, theglobal population needs to reduce consumption by 25 percent to consume and processour wastes sustainably (Wackernagel et al., 2002). The assessment by theIntergovernmental Panel on Climate Change (2007) indicates that we need to reducegreenhouse gas (GHG) emissions by 80 percent globally by 2050 to avoid harmful, ifnot catastrophic, climate change. Hansen et al. (2008) argue that we have alreadypassed the point of catastrophic climate change and need to reduce the existing level ofGHGs in the atmosphere. The Millennium Ecosystem Assessment (2005, p. 1) argues:

The changes that have been made to ecosystems have contributed to substantial net gains inhuman well-being and economic development, but these gains have been achieved at growingcosts in the form of the degradation of many ecosystem services, increased risks of nonlinearchanges, and the exacerbation of poverty for some groups of people. These problems, unlessaddressed, will substantially diminish the benefits that future generations obtain fromecosystems.

Making these adjustments in how we use the earth so as to not impose unjust costs onfuture generations while responding to the global injustices already at hand will be amajor effort. Not surprisingly, however, some economists are arguing that thealignment will not be that difficult because gross domestic product will only bemarginally reduced. Again, assessing whether the accommodation with reality willentail hardships cannot be determined by looking at markets. GDP went up during theSecond World War while thousands died, millions lost relatives and were themselvesdisplaced, and additional millions died early of hunger and disease.

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Beyond economismWe need to put much more effort into being informed of underlying conditions formarkets to work well, and this is both more critical and difficult when markets entailgreat distances and complex transactions. How can a society taking advantage of thegains from specialisation and exchange, a process that wedges people apart fromreality and the moral implications of their decisions, be both informed and moral? Oneanswer is clearly that being informed and moral are necessary for market stability,sustainability and justice, and put some serious limits on the optimal extent ofexchange (Norgaard and Liu, 2007; Norgaard and Jin, 2008). While economists are fondof noting that there are always tradeoffs and optima, one of the myths of economismhas been that expanding the extent of trade is always good. There are costs toexpanding markets that offset the benefits, and optimal markets may be quiteconstrained compared to those of today.

To be better informed of reality and more moral, we probably need to deliberatelyset up some new institutions to facilitate these goals. The Millennium EcosystemAssessment (MA) proved to be an interesting example of a collective process forassessing reality, discussing morality, and confronting economism (Norgaard, 2008).Some 1,400 scientists from around the world participated in a review and evaluation ofthe existing literature on the status and importance of ecosystems and their servicesand the drivers forcing their degradation. Participants from developing countriesrepeatedly pointed out that the values of environmental services as determinedthrough market prices or behavior were heavily weighted by who had the income topay for them. The prices of ecosystem services reflected the tastes and concerns of therich more than the poor. The dollars of rich ecotourists spent on international airfaresare weighted the same as the dollars of the poor spent on bus fares to get to work. ThusMA participants readily saw how markets to save trees to sequester carbon, forexample, are being established in poor nations where the poor are “willing” to stopusing forests because the rich have the economic power to buy up the rights of the poorto stop them from using other ecosystem services of the forest. As a consequence,carbon sequestration is cheaper than it would be in a world with less income disparity.The rich can continue to drive their SUVs because the poor are willing to forego usingtheir forests for little. Once this was made clear within the MA process, it was verydifficult to use prices generated in markets as neutral values. In short, the openparticipatory process of the MA began to deconstruct economism (Norgaard, 2008).

Another major contradiction of market-based valuation appeared in the MillenniumEcosystem Assessment. Several scientists noticed that for there to be any rationality torelying on stated preferences or behaviour to derive the values of environmentalservices, one would have to assume that lay people were sufficiently informed of thevery ecological complexities the MA scientists were struggling to understand. Thisassumption contradicted the objective of the MA to provide much needed knowledge tothe public and policymakers. In short, as with the problem of measuring resourcescarcity by looking at prices over time (Norgaard, 1990), the problems of usingmonetary values to weight ecosystem services are tightly embedded in the verysocioeconomic system driving the problems of ecosystem degradation the MA soughtto understand in order to design better socioeconomic policies. This circularityhighlights how difficult it is to understand nature without looking through theeconomy with the aid of economism. Yet MA participants were able to share their


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expertise into a very rich understanding of reality while also holding serious moraldiscussions.

The experience that Pavan Sukhdev (with Haripriya Gundimedia and PushpamKumar) gained in India trying to give economic values to non-timber products fromforests, and to other environmental services (such as carbon uptake, water and soilretention), has been an inspiration for the Economics of Ecosystems and Biodiversity(TEEB) process sponsored by DG Environment of the European Commission. As theTEEB team states, a monetary representation of the services provided by clean water,access to wood and pastures, and medicinal plants, does not really measure theessential dependence of poor people on such resources and services. In their project“Green Accounting for India” they found that the most significant direct beneficiariesof forest biodiversity and ecosystem services are the poor, and the predominant impactof a loss or denial of these inputs is on the well-being of the poor. The poverty of thebeneficiaries makes these losses more acute as a proportion of their “livelihoodincomes” than is the case for the people of India at large. Hence the notion of “the GDPof the poor”: for instance, when water in the local river or aquifer is polluted because ofmining, they cannot afford to buy water in plastic bottles. Therefore, when poor peoplesee that their chances of livelihood are threatened because of mining projects, dams,tree plantations, or large industrial areas, they complain not because they areprofessional environmentalists but because they need the services of the environmentfor their immediate survival (see http://ec.europa.eu/environment/nature/biodiversity/economics/index_en.htm).

Regional ecosystem assessments are now under way and there are numerous otherfora that bring people together to debate underlying conditions and appropriatecollective behaviour. We need to expand these and enter into them with a largerperspective on their role in offsetting the simplicities of economism.

Beyond growthThe economic crisis will reduce CO2 emissions and it might slow down the acceleratingroute to biodiversity destruction and climate change. On the other hand, it might alsolead to the reduction of public and private expenditure on green technologies orpollution control. There is no doubt also that recession will hit lower-income groupsand countries unevenly. But the problem with the above framing is that it is stillcouched in the terms of economism and growth. There is a sense of deja vu with theinterest rate debate (where high interest rates are supposed to make environmentallydestructive projects uneconomical but also slow down environmental investments).Environment and jobs, environment and the poor are positioned at opposing ends,eco-friendly growth supposedly being the only way to reconcile them. But these arefalse dilemmas.

What we need is an altogether different vision and framing along the lines of anAristotelian buen vivir (as the World Social Forum proclaims) guided by oikonomiarather than chrematistics. Here we emphasise the transformative potential of aneconomic crisis, a crisis that many ecological economists said would come sooner orlater given the unsustainable pattern of capitalist growth. Now it is the moment togenerate new social visions of living well and being happy without the imperative ofeconomic growth. Visions that render compatible living well, working satisfactory andmaintaining our local and global ecosystems.

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The concept of decroissance soutenable, or socially sustainable economic de-growth,which Georgescu-Roegen started 30 years ago, is relevant (Latouche, 2004). De-growthis not about decreasing GDP because we might always change accounting conventionsand include in GDP other items (unpaid domestic and voluntary work) and deduct thenegative externalities of biodiversity destruction, climate change, loss of humancultures. Sustainable de-growth is about creating an alternative, smaller economy,suitable to the physical needs of humans and ecosystems. With the economic crisis, ladecroissance est arrivee in Europe, the USA and Japan. This is an opportunity formoving with the socio-ecological transition. The challenge is how to manage thetransition to a smaller economy in a socially equitable way, where those that levy thegreater burden are those that already “have” and who benefited the most from the pastpattern of unsustainable accumulation. At first sight, Southern countries havesomething to lose and little to gain from de-growth in the North: fewer opportunities forcommodity and manufactured exports, less availability of credits and donations. But,the movements for environmental justice and the “environmentalism of the poor” of theSouth are the main allies of the sustainable de-growth movement of the North. Thesemovements complain against disproportionate pollution (at local and global levels,claims for repayment of the “carbon debt”) and waste exports from North to South (e.g.“Clemenceau” to Alang in Gujarat, or electronic waste). They resist biopiracy andRaubwirtschaft, i.e. ecologically unequal exchange, destruction of nature and humanlivelihoods at the “commodity frontiers”. They claim the socio-environmental liabilitiesof transnational companies (Martinez-Alier, 2002). Their objectives are to have aneconomy that sustainably fulfils the food, health, education and housing needs foreverybody. This transition to a smaller, human and ecological-scale economy is noteasy. The question is how to manage it smoothly and redistribute its costs to those thatmost benefited by the unsustainable path that brought us here. De-growth is notapolitical. It calls for a radically new polity with a redistribution of political andeconomic power to allow it to be fulfilled.

References

Barnett, H.J. and Morse, C. (1963), Scarcity and Growth, Johns Hopkins University Press,Baltimore, MD.

Boulding, K.E. (1966), “The economics of the coming Spaceship Earth”, in Jarrett, H. (Ed.),Environmental Quality in a Growing Economy: Essays from the Sixth RFF Forum, JohnsHopkins University Press, Baltimore, MD, pp. 3-14.

Daly, H.E. (1991), Steady-State Economics, 2nd ed., Island Press, Washington DC.

Daly, H. (2008), “Credit crisis, financial assets and real wealth”, The Oil Drum, October 13,available at: www.theoildrum.com

Deffeyes, K.S. (2001), Hubbert’s Peak: The Impending World of Oil Shortages, PrincetonUniversity Press, Princeton, NJ.

Financial Times (2008), “Crude falls on clear signs of weak demand”, Financial Times, 23 October,p. 30.

Georgescu-Roegen, N. (1971), The Entropy Law and the Economic Process, Harvard UniversityPress, Cambridge, MA.

Giampietro, M. (2003), Multi-scale Integrated Analysis of Agroecosystems, CRC Press,Boca Raton, FL.


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Hansen, J., Sato, M., Kharecha, P., Beerling, D., Berner, R., Masson-Delmotte, V., Pagani, M.,Raymo, M., Royer, D.L. and Zachos, J.C. (2008), “Target atmospheric CO2: where shouldhumanity aim?”, Open Atmospheric Science Journal, Vol. 2, pp. 217-31.

Harvey, D. (1996), Justice, Nature and the Geography of Difference, Blackwell, Oxford.

Intergovernmental Panel on Climate Change (2007), Summary for Policymakers. The PhysicalScience Basis. Working Group 1 Contribution to the Fourth Assessment Report of the IPCC,Cambridge University Press, Cambridge.

Kapp, K.W. (1970), “Environmental disruptions and social costs: a challenge to economists”,Kyklos, Vol. 23, pp. 833-47.

Kosoy, N. (2008), “Branded nature and fictitious commodity fetishism”, Ecological Economics,submitted for publication.

Latouche, S. (2004), “De-growth economics”, Le monde diplomatique (English edition), November.

Lomborg, B. (2001), The Skeptical Environmentalist: Measuring the Real State of the World,Cambridge University Press, Cambridge.

Martinez-Alier, J. (1990), Ecological Economics: Energy, Environment and Society, BasilBlackwell, Oxford.

Martinez-Alier, J. (2002), The Environmentalism of the Poor: A Study of Ecological Conflicts andValuation, Edward Elgar, Cheltenham.

Martinez-Allier, J., Munda, G. and O’Neill, J. (1998), “Weak comparability of values as afoundation for ecological economics”, Ecological Economics, Vol. 26, pp. 277-86.

Millennium Ecosystem Assessment (2005), Ecosystems and Human Well-Being: Synthesis,Island Press, Washington, DC.

Norgaard, R.B. (1990), “Economic indicators of resource scarcity: a critical essay”, Journal ofEnvironmental Economics and Management, Vol. 19, pp. 19-25.

Norgaard, R.B. (1994), Development Betrayed: The End of Progress and a CoevolutionaryRevisioning of the Future, Routledge, London.

Norgaard, R.B. (2008), “Finding hope in the Millennium Ecosystem Assessment”, BioScience,Vol. 22 No. 4, pp. 862-9.

Norgaard, R.B. and Jin, L. (2008), “Trade and the governance of ecosystem services”, EcologicalEconomics, Vol. 66 No. 4, pp. 638-52.

Norgaard, R.B. and Liu, X. (2007), “Market governance failure”, Ecological Economics, Vol. 60No. 3, pp. 634-41.

Polanyi, K. (1944), The Great Transformation, Beacon Press, Boston, MA.

Polimeni, J.M., Mayumi, K., Giampietro, M. and Alcott, B. (2008), The Jevons Paradox and theMyth of Resource Efficiency Improvements, Earthscan, London.

Simon, J. (1981), The Ultimate Resource, Princeton University Press, Princeton, NJ.

Soddy, F. (1926), Wealth,Virtual Wealth and Debt, E.P. Dutton, New York, NY.

Spash, C.L. (1999), “The development of environmental thinking in economics”, EnvironmentalValues, Vol. 8, pp. 413-35.

Srinivasan, U.T., Carey, S.P., Hallstein, E., Higgins, P.A.T., Kerr, A.C., Koteen, L.E., Smith, A.B.,Watson, R., Harte, J. and Norgaard, R.B. (2008), “The debt of nations and the distribution ofecological impacts from human activities”, Proceedings of the National Academy ofSciences, Vol. 105 No. 5, pp. 1768-73.

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Vatn, A. and Bromley, D.W. (1994), “Choices without prices without apologies”, Journal ofEnvironmental Economics and Management, Vol. 26, pp. 129-48.

Wackernagel, M., Schulz, N.B., Deumling, D., Callejas Linares, A., Jenkins, M., Kapos, V., Loh, J.,Myers, N., Norgaard, R.B., Randers, J. and Monfreda, C. (2002), “Tracking the ecologicalovershoot of the human economy”, Proceedings of the National Academy of Sciences,Vol. 99, pp. 9266-71.

About the authorsGiorgos Kallis is an ICREA fellow at the Autonomous University of Barcelona. He previouslyheld an EC Marie Curie Outgoing Fellowship at the University of California at Berkeley. Heresearches the co-evolution of ecological-economic systems, environmental justice andadaptation to climate change. Giorgos Kallis is the corresponding author and can becontacted at: [email protected]

Joan Martinez-Alier is Professor at the Department of Economics and Economic History, atthe Autonomous University of Barcelona. He is among the founders and a former president of theInternational Society for Ecological Economics. His current research focuses on ecologicaleconomics and languages of valuation, political ecology, environmental justice and theenvironmentalism of the poor.

Richard Norgaard is Professor of Energy and Resources at the University of California,Berkeley. He earned his PhD in Economics at the University of Chicago, has been a constructivecritique of neoclassical economics, and is among the founders and a former president of theInternational Society for Ecological Economics. His current research stresses how scientistscollectively and discursively understand complex systems and the implications of this fordemocracy and ecological governance.


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The global financial crisis:an institutional theory analysis

Suhaib RiazFaculty of Business and IT, University of Ontario Institute of Technology,

Oshawa, Canada

Abstract

Purpose – This paper seeks to provide insights into the current global financial crisis from aninstitutional theory perspective.

Design/methodology/approach – The paper presents the development of key concepts usinginstitutional theory, grounded in a discussion of the context of the current global financial crisis.

Findings – The interplay of financial industry organizations and formal and informal institutions iskey to understanding the creation of the crisis.

Research limitations/implications – The treatment is brief but serves to provoke further researchon the global financial crisis through applying and extending new institutional theory.

Practical implications – Fundamental aspects of the crisis need to be understood with respect tothe organizational-institutional interplay involving the financial industry. This would help to revealthe general pattern of such crises and also point towards what needs to be taken into account forpotential solutions.

Originality/value – The paper has value for researchers as it opens up a discussion of the currentcrisis from an institutional theory perspective. Fresh concepts introduced here could be extendedfurther and inform institutional theory in general. The paper has value for policy makers andpractitioners in helping them understand the fundamentals of the organizational-institutionalinterplay underlying the current crisis.

Keywords Recession, Financial institutions, Organizational structure

Paper type Viewpoint

1. IntroductionThe current economic crisis, rapidly gaining ground across the world everyday, hasbeen appropriately labeled as a “global financial crisis”. News stories focus on thecollapse of banks and financial services organizations that until recently were deemedto be very successful and highly legitimate businesses. How could such successfulbusinesses suddenly collapse and lose all legitimacy? How could the entire industry ofinvestment banking lose legitimacy to the point where popular financial media reporton the embarrassment of investment bankers at dinner parties?

While the current crisis has several aspects that can be understood using variousdisciplines and theoretical lenses, new institutional theory (DiMaggio and Powell, 1983;Meyer and Rowan, 1977) can provide a unique perspective for understanding keyaspects of the organizational-institutional interplay in the unfolding of the presentcrisis. In some ways, this situation is not new, and similar elements have beenwitnessed in prior crises and bubble bursts. There is an opportunity here to understand



The author would like to thank participants at the McGill-Cornell Conference on Institutions andEntrepreneurship and at the Academy of Management OMT division for feedback on conceptspresented here, with special thanks to Dr Richard Scott for feedback and encouragement.

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these crises in a broader manner with theoretical insights that draw out the generalpattern. Theoretical insights grounded in a discussion of the current global financialcrisis can therefore provide a unique opportunity in understanding the fundamentals ofsuch crises in general, rather than simply documenting the facts as they unfold.

I suggest that the current crisis calls for examination as an institutional crisis,resulting from the interplay of the financial industry organizations and broader formaland informal institutions. Such an examination requires understanding themechanisms of organizational-institutional interplay that follow from basic tenets ofnew institutional theory. In this position paper, I draw upon the formal theoreticalapparatus of new institutional theory and extend its core ideas to help explain theunfolding of the present crisis.

2. Institutional theory and the crisis: a view of the iron cage, inside-outIn this section, I present theoretical arguments to throw light on the interplay offinancial industry organizations with formal and informal underlying institutions,including the international dimensions of the crisis through the build up of a“contagion of legitimacy”.

For analytical purposes, I consider the investment banks and financial servicesorganizations comprising the finance industry as organizations that exist within thewider framework of formal and informal institutions. I focus specifically on the UScontext, though the ideas extend to several affected regions of the world. The formalregulative institutions (Scott, 2001) include the central bank – The Federal Reserve,The Treasury and The Securities and Exchange Commission (SEC) – while theinformal normative and cultural-cognitive institutions (Scott, 2001) include the culturalacceptance of debt, high mortgages, disregard for savings, and an aggressiveinvestment-oriented culture that involves even pension funds and 401K accounts asactive investors in high-risk equity and debt securities.

The new institutionalism has, as one of its core defining symbols, the “iron cage” ofhomogenization put forward by DiMaggio and Powell (1983), building on Weber’s ideaof the iron cage of bureaucratization. In this perspective, organizations are viewed as“imprisoned” by institutions through the powerful processes of institutionalisomorphism. While this visual is apt in describing the influence that theinstitutional environment has on organizations in general, this is only half thepicture. The flip side to this is a view of the iron cage inside-out, that reveals theprominent role organizations have in influencing institutions. While the functioning ofinstitutions and their influence on organizations has been much explored, the processesof creation, maintenance, demise and death of institutions have only recently receivedsome attention. This theoretical problem has been described as a concern with thesilences of institutional theory, rather than a rejection of its core tenets (Brint andKarabel, 1991). Half of a full sociology of institutions is thus a work in progress, and iskey to understanding situations such as the current financial crisis. The need for workin this area has been highlighted by prominent proponents of institutional theory(DiMaggio and Powell, 1991), and recently, several attempts have been made to coverthis gap (e.g. Battilana, 2006; Greenwood and Suddaby, 2006; Garud et al., 2002;Galaskiewicz, 1991; Brint and Karabel, 1991; DiMaggio, 1991; Fligstein, 1991).

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These emerging ideas on institutional formation, institutional development,deinstitutionalization and reinstitutionalization (Jepperson, 1991) have much to informour understanding of the complexities of organizational-institutional interplay incontexts such as the present crisis. However, several of these ideas have been alludedto in empirical works but have not been brought together through theoreticaldevelopment that would help us understand the issues in an integrated manner. Here Idraw upon and extend these ideas to help us understand the unfolding of the currentfinancial crisis. In the sections below, I present key concepts, such as“reverse-legitimacy”, “illegitimate structures” and “institutional crisis”, that extendand integrate some of this emerging work and are particularly useful forunderstanding the current crisis from a theoretical perspective.

That organizations themselves can be the means, and organization-institutioninteractions be the processes through which power and interests are made to bear uponinstitutions (e.g. Greenwood and Suddaby, 2006; Garud et al., 2002) is a particularlyuseful view for understanding the creation and maintenance of the institutionalframework underlying the current crisis. Organizations represent powerful interests(which could be considered their own or those of their agents) that have a bearing onthe survival of the institutional framework in the domain of the organization’soperation and influence. I contend that many institutions, in fact, cannot survive todaywithout the active support and sanction of organizations. This is particularly valid forthe formal and informal institutional framework underlying the financial industryorganizations.

I thus argue that the “engine” of institution-organization influence identified byDiMaggio and Powell (1983) works both ways in its effects. Things have indeedchanged since the times of Weber, but one important change is in the power andinfluence wielded by organizations, particularly business and financial industryorganizations, all over the world today. Assuming that multinational organizationswith budgets far exceeding those of several countries put together are necessarilypassive players submissively seeking legitimacy in their interaction with institutions isan anachronistic thought. Business and financial organizations today are powerfulbeyond imagination, and have a role in influencing, shaping and manipulatinganything that happens to be in the way of their survival and success. And what elsecould be more “in their way” than institutions? While institutions attempt to imposetheir constraints on organizations, organizations are busy twisting the iron cageinside-out over the institutions, i.e. determining through their actions whichinstitutions survive and succeed in their domains. In today’s world, the powerequation between organizations and institutions is such that one’s answer to “Who iscaged?” with respect to the organizational-institutional interplay might well depend onthe perspective one chooses, i.e. from which side of the iron mesh one views the world.

2.1 Reverse-legitimacyDiMaggio and Powell (1983) concede the active role of organizations when they statethat organizations try to change constantly, yet the aggregate effect of such change ishomogenization. I argue that this homogeneity could also serve to legitimate theinstitutions whose forces underlie the institutional isomorphic processes. This mutual

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legitimation could give rise to a “contagion of legitimacy” amongst the organizationsand institutions involved.

Institutions have power over organizations to the extent that they can grantlegitimacy to organizations, or can make an organization that does not conform toinstitutional pressures “illegitimate”. I contend that with the emergence of powerfulbusiness and financial organizations, this “legitimacy” flows both ways. Not only doesthe appearance of conformance to institutional pressures have a role in organizationalsuccess, but organizational success in turn confers a “reverse-legitimacy” upon certaininstitutions that are deemed to have had a role in the success of organizationsassociated with these institutions.

If organizations within the organizational field are successful in the aggregate, theinstitutions from which the organizations have sought legitimacy (through conformingto the isomorphic pressures generated by these institutions) are sanctioned as havingbeen responsible for giving rise to such successful organizations. In reality, the successof organizations could be dependent on several other factors internal or external tothemselves, yet their association with certain institutions provides these institutionswith the “halo” of success. One sees such situations when certain public policydecisions are made to replicate institutions that are deemed to have contributed to, oreven given rise to, successful organizations (Jepperson and Meyer, 1991).

This is most dramatically discernible in the clear attempt by less developedcountries to imitate institutions from countries where powerful business and financialorganizations have succeeded, and to then invite these powerful organizations to thehost countries and hope for similar success of these and similar organizations. Theproliferation of “free trade zones”, “special economic zones”, “commercial regions”, etc.,in parts of the world that generally do not have institutions similar to the developedworld is partly an attempt to provide powerful organizations with institutionalstructures of their liking, in which they have succeeded elsewhere.

Thus, organizations can “reverse-legitimate” institutions in the same way thatinstitutions “legitimate” organizations. The institutional environment has beenthought of as consisting of institutions nesting with one another (Jepperson, 1991), andof interrelated networks of mutually supportive or antagonistic parts, giving rise to“contagions of legitimacy” (Zucker, 1977). The concept of “contagions of legitimacy” isa useful one, with my additional insight being that business and financialorganizations are a core part of such contagions, due to the ability of powerfulbusiness and financial organizations today to “reverse-legitimate” institutions throughtheir own success. Groups of institutions and organizations form “contagions oflegitimacy” and the survival or failure of institutions or organizations in suchcontagions is intricately connected. The concept of “reverse-legitimacy”, related to theidea of “contagions of legitimacy” is much needed to allow for further theoreticaldevelopment of ideas that have been presented in empirical works in this domain (e.g.Greenwood and Suddaby, 2006; Garud et al., 2002).

The above concepts and arguments serve to highlight key aspects of the currentcrisis. The success of business organizations in the finance industry, in the aggregate,conferred a “halo” effect on the underlying formal and informal institutional structures,which were reverse-legitimated and put beyond question. For example,mortgage-backed securities proliferated since the chain of organizations involved in


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their creation, securitization, insurance and rating, comprised of successfulorganizations in the aggregate, which helped sanction the formal regulatoryinstitutions (particularly the Securities and Exchange Commission, but also theFederal Reserve and its credit expansion and inflationary policies) and also informalcultural-cognitive and normative institutions (for example, the cultural acceptance ofhigh debt and excessive home mortgages).

This “reverse-legitimation” of institutions underlying the financial industry successalso had international ramifications as theoretically delineated above. The institutionaltransformations associated with the financial industry in emerging markets (e.g. Chinaand India) and transition countries (e.g. Eastern Europe), both in terms of the formalregulatory institutions and also in terms of the cultural-cognitive and normativeinstitutions suggest attempts at replication of features of American and WesternEuropean “successful” institutions. For example, countries where cultural-cognitiveand normative institutions had historically pushed people to save saw a cultural shiftand a move towards acceptance of debt, while the regulatory institutions eased up toallow financial organizations to set up businesses similar to ones they had succeeded inelsewhere. A “contagion of legitimacy” was therefore created that primarily includedthe financial organizations in the USA and Western Europe along with the formal andinformal institutions underlying this industry’s success in this part of the world. Overtime, this contagion spread across several parts of the globe where these and similarfinancial organizations set up businesses and features of the underlying formal andinformal institutions were replicated.

In summary, I propose the following: while conforming to institutional pressures,powerful organizations, through their success, can “reverse-legitimate” the institutionsthat underlie these pressures, and this reverse-legitimation has a positive effect on thesurvival and continuation of the concerned institutions. Further, “reverse-legitimation”can lead to institutional formation through attempts at replication of the “successful”institutions where such institutions do not currently exist. In the context of the currentcrisis, financial organizations in the USA, through their success in the aggregate, wereable to reverse-legitimate formal and informal institutions in the USA, and thisreverse-legitimation led to replication of these institutions in other parts of the world,particularly in emerging economies that tried to replicate elements of this success.

2.2 Illegitimate structures and institutional crisisWhile organizational success in the aggregate reverse-legitimates institutions, this isno guarantee of organizational conformance to all pressures from the underlyinginstitutional framework. Though organizations derive legitimacy through the“contagion of legitimacy”, they can further manipulate the legitimacy-grantingprocess through strategies that help avoid institutional pressures not in line with partsof their structure (Kraatz and Zajac, 1996; Suchman, 1995). Under certain conditions,the “contagion of legitimacy” could then head for a crisis. These theoretical argumentsare delineated here and relevant to understanding how the current crisis developed andwhere such crises could lead.

Organizations use a strategy of decoupling when faced with institutional pressuresnot in line with their existing structures (Meyer and Rowan, 1977). This involvessymbolic conformance to the institutional pressures through the organization’s

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institutional layer, and substantive non-conformance in technical aspects (Ashforthand Gibbs, 1990). Oliver describes similar strategic responses as “conceal” and “buffer”mechanisms, i.e. when an organization disguises non-conformity behind a facade ofacquiescence or loosens institutional attachments, respectively (Oliver, 1991; Oliver,1996). I extend these ideas to see the major implications such organizational strategieseventually have on the fortunes of the institutions involved.

I argue that a strategy of decoupling or concealment by powerful and successfulorganizations, prolonged over a period of time, has a negative effect on the survival ofsuch institutions. Initially, while organizations attempt to comply in substantive terms,a few might discover ways to conceal compliance or comply only in symbolic termswhile leaving their substantive aspects free from institutional pressures. The ability tocarry out such a decoupling or concealment confers an advantage to these feworganizations over others, since they are able to derive legitimacy from the institutionsin question, and at the same time keep their technical or substantive aspects free toperform as necessary for efficiency reasons. Once such a strategy is discovered andimplemented as a successful way of dealing with “undesirable” pressures frominstitutions, other organizations in the organizational field then mimic this strategy,particularly if it is followed by some of the more powerful and successfulorganizations.

The situation is made worse by the ability of powerful organizations to manipulate(Oliver, 1991) the concerned institutions as well. Manipulation could be undertaken sothat the organization does not have to conceal altogether, or, often more easily andconveniently, it could be undertaken to make such concealment and decouplingstrategies easier to execute. The latter strategy relates to weakening the ability ofinstitutions to detect concealment and decoupling (non-conformity of organizations insubstantive terms), and is important for our analysis.

As more organizations discover and implement decoupling and concealmentstrategies, and as implementation of such strategies becomes easier due tomanipulation of the institutions by the more powerful organizations, theorganizational field heads towards a legitimacy crisis. While the pursuance ofsymbolic conformance creates a heightened perception of organizational legitimacy tothose outside the organizational field, internally, the organizations are replete with“illegitimate” substantive structures. Thus, a sustained strategy of decoupling,concealment and manipulation by organizations leads to heightened perception oflegitimacy (for organizations comprising the organizational field) to those outside theorganizational field, while increasing “illegitimate” structures within the field.

The homogenization of the field is thus achieved, in part, through organizationalstrategies that make “illegitimate” structures widely prevalent. The scenario is akin tothat of a bubble, or a house of cards. At some stage, if the “illegitimacy” of a feworganizations, particularly the more successful ones, within the organizational fieldbecomes well-known outside the field, a domino effect occurs whereby the legitimacyof all organizations that have until now been considered as complying in all theiraspects becomes suspect. Most importantly for our purpose, this has a dramatic effecton the institutions involved as well, since their legitimacy-granting powers becomesuspect: they are seen as having bestowed “legitimacy” to organizations with


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“illegitimate” structures within the organizational field. The case of investment banksin the USA is particularly relevant here.

Investment banks needed to avoid institutional pressures that were in conflict withsubstantive aspects of the banks’ operations related to subprime mortgage risks, yetthe nature of their businesses is such that they need to be seen as legitimate. Toovercome this problem, banks resorted to a strategy of decoupling or concealment.They remained exposed to the high risk of subprime mortgages in substantive terms,while maintaining legitimacy in symbolic aspects. Pursuing a strategy of decoupling orconcealment, along with manipulation where possible, helped banks carry on thesesubstantive operations while maintaining the symbolic legitimacy, for a while. Suchsituations are, however, too good to last. Once the discovery of “illegitimate” structureswithin powerful and successful investment banks became public knowledge outsidetheir field, the legitimacy of all investment banks along the relevant dimensionsbecame suspect.

We therefore see how the domino effect spread through the largest Wall Streetinvestment banks and other financial industry organizations, shaking up the entirefinancial industry and organizations beyond that were deeply connected to thisindustry. Three of Wall Street’s five large banks ceased to be legitimate independentbusinesses within six months. Bear Sterns was bought by JPMorgan, Lehman Brothersfiled for bankruptcy, and Merrill Lynch faced bankruptcy and was bought by Bank ofAmerica. A key aspect here is the change in organizational form to escape thelegitimacy crisis due to the deinstitutionalization of their erstwhile organizationalforms (Davis et al., 1994) that were part of the earlier “contagion of legitimacy”. Forexample, Goldman Sachs and Morgan Stanley changed organizational form to ceasebeing specialized investment banks and became deposit holding banks. Bear Sternsand Merrill Lynch, earlier highly legitimate specialized investment banks, in effectchanged organizational form through being acquired by universal banks JPMorganand Bank of America, respectively. As the crisis spread across the erstwhile “contagionof legitimacy”, other organizations in the field faced a sudden loss of legitimacy:mortgage giants Fannie Mae and Freddie Mac had to be saved through nationalizationand insurance behemoth American Insurance Group asked to be saved by agovernment loan.

Ultimately, formal institutions also bear the brunt of this collapse of the “contagionof legitimacy”, as they could lose their legitimacy granting powers and be themselvesconsidered illegitimate. In the present scenario, skepticism is currently on the riseregarding the legitimacy granting powers of the Federal Reserve through its creditexpansion and inflationary policies, the Treasury, the SEC, and governmental effortsbased on these institutions to stabilize and provide legitimacy to the financial industryorganizations. Similarly, informal institutions, such as the cultural-cognitive andnormative acceptance of aggressive high-risk investments, high debt, excessivemortgages, disregard for savings, etc., are in question, and taken for grantedassumptions about these are challenged. In other words, these informal institutionslose their legitimacy granting powers that bestowed legitimacy on financial industryorganizations. This questioning and challenge of the formal and informal institutionsis what manifests itself as widespread behavior that results in the flight of funds fromequities, banks and other financial organizations, and even from money markets and

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bonds. In other words, the legitimacy of all players that were part of the erstwhile“contagion of legitimacy” comes into question and an institutional crisis ensues.

3. DiscussionIn this paper, I support the use of the emerging literature in new institutional theory onthe interplay of organizations and institutions to understand the current financialcrisis. I provide fresh concepts and theoretical arguments on how organizations,particularly powerful and successful ones, could have an impact on the fortunes ofinstitutions in their operating domains. My view is that a two-way influence in theinstitution-organization interplay has to be expected, particularly considering theexistence of highly powerful and successful organizations today, that actively pursuetheir own interests (or those of their controlling agents). In other words, I argue forlooking at the iron cage of DiMaggio and Powell (1983), inside-out, to use the sameimagery, in order to understand the current global financial crisis.

The ideas presented here are useful to explain the present financial crisis byfocusing on the major players in the financial industry and major formal and informalinstitutions relevant to these players. However, the organizations and institutionsconsidered here could also be extended to include a broader set of players in the globalarena. Further, the interplay between organizations and institutions could be exploredfurther at a finer level of granularity. For example, the recent International MonetaryFund involvement in the present crisis in countries such as Ukraine, and the EuropeanCentral Bank providing credit to Hungary, could constitute cases for more detailedanalysis using the concepts discussed here. In particular, cross-borderorganizational-institutional interplay, such as that arising from the banking industrydisputes between Iceland and the UK, could comprise interesting topics of researchusing new institutional theory. New theoretical insights could be developed throughgrounding future research in such contexts and extending the conceptual ideaspresented in this paper.

The analysis in this paper suggests that those working for resolutions shouldattempt to understand the complex interplay of financial industry organizations andbroader institutions, particularly with an emphasis on how this interplay providesperceptions of legitimacy to both parties. Simplistic notions of institutions pressurizingorganizations in the organizational field to conform in order to seek legitimacy do notalways apply, and could prove futile yet again in the future. The reality is morecomplex and notions of “reverse-legitimacy” and “contagions of legitimacy” are moreuseful. Fundamental questions about the nature of these institutions and theirlegitimacy-granting powers need to be raised, along with a focus on the powers thatbusiness and financial organizations, individually and collectively wield to“reverse-legitimate” these institutions. Further, wide use of decoupling strategies bybusiness and financial organizations, such as the case of investment banks andhigh-risk mortgage-backed securities, could eventually trigger institutional crises thatcall into question legitimacy-granting powers of existing formal and informalinstitutions.

The current crisis thus calls for examination as an institutional crisis resulting fromthe interplay of the involved financial industry organizations and broader formal andinformal institutions. This paper provided theoretical insights to enable our


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understanding of this interplay and potentially shape future policy relevant to thiscrisis and to similar potential crises in the future. Through grounding theoreticalarguments in the context of the present crisis, this paper also introduced new conceptsthat would further theoretical and empirical work within emerging streams of newinstitutional theory.

References

Ashforth, B.E. and Gibbs, B.W. (1990), “The double-edge of organizational legitimation”,Organization Science, Vol. 1 No. 2, pp. 177-94.

Battilana, J. (2006), “Agency and institutions: the enabling role of individuals’ social position”,Organization, Vol. 13 No. 5, pp. 653-76.

Brint, S. and Karabel, J. (1991), “Institutional origins and transformations: the case of Americancommunity colleges”, in Powell, W. and DiMaggio, P. (Eds), The New Institutionalism inOrganizational Analysis, The University of Chicago Press, Chicago, IL, pp. 337-60.

Davis, G.F., Diekmann, K.A. and Tinsley, C.H. (1994), “In the 1980s: the deinstitutionalization ofan organizational form”, American Sociological Review, Vol. 59, pp. 547-70.

DiMaggio, P. (1991), “Constructing an organizational field as a professional project: US artmuseums, 1920-1940”, in Powell, W. and DiMaggio, P. (Eds), The New Institutionalism inOrganizational Analysis, The University of Chicago Press, Chicago, IL, pp. 267-92.

DiMaggio, P. and Powell, W. (1983), “The iron cage revisited: institutional isomorphism andcollective rationality in organizational fields”, American Sociological Review, Vol. 48,pp. 147-60.

DiMaggio, P. and Powell, W. (1991), “Introduction”, in Powell, W. and DiMaggio, P. (Eds),The New Institutionalism in Organizational Analysis, The University of Chicago Press,Chicago, IL, pp. 1-38.

Fligstein, N. (1991), “The structural transformation of American industry: an institutionalaccount of the causes of diversification in the largest firms, 1919-1979”, in Powell, W. andDiMaggio, P. (Eds), The New Institutionalism in Organizational Analysis, The Universityof Chicago Press, Chicago, IL, pp. 311-36.

Galaskiewicz, J. (1991), “Making corporate actors accountable: institution-building inMinneapolis-St Paul”, in Powell, W. and DiMaggio, P. (Eds), The New Institutionalismin Organizational Analysis, The University of Chicago Press, Chicago, IL, pp. 293-310.

Garud, R., Jain, S. and Kumaraswamy, A. (2002), “Institutional entrepreneurship in thesponsorship of common technological standards: the case of Sun Microsystems and Java”,Academy of Management Journal, Vol. 45 No. 1, pp. 196-214.

Greenwood, R. and Suddaby, R. (2006), “Institutional entrepreneurship by elite firms in maturefields: the big five accounting firms”, Academy of Management Journal, Vol. 49 No. 1,pp. 27-48.

Jepperson, R.L. (1991), “Institutions, institutional effects, and institutionalization”, in Powell, W.and DiMaggio, P. (Eds), The New Institutionalism in Organizational Analysis,The University of Chicago Press, Chicago, IL, pp. 143-63.

Jepperson, R.L. and Meyer, J.W. (1991), “The public order and the construction of formalorganizations”, in Powell, W. and DiMaggio, P. (Eds), The New Institutionalism inOrganizational Analysis, The University of Chicago Press, Chicago, IL, pp. 204-31.

Kraatz, M.S. and Zajac, E.J. (1996), “Exploring the limits of the new institutionalism: the causesand consequences of illegitimate organizational change”, American Sociological Review,Vol. 61, pp. 812-36.

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Meyer, J.W. and Rowan, B. (1977), “Institutionalized organizations: formal structure as myth andceremony”, American Journal of Sociology, Vol. 83, pp. 340-63.

Oliver, C. (1991), “Strategic responses to institutional processes”, Academy of ManagementReview, Vol. 16 No. 1, pp. 145-79.

Oliver, C. (1996), “The institutional embeddedness of economic activity”, Advances in StrategicManagement, Vol. 13, pp. 163-86.

Scott, W.R. (2001), Institutions and Organizations, Sage Publications, Thousand Oaks, CA.

Suchman, M.C. (1995), “Managing legitimacy: strategic and institutional approaches”, Academyof Management Review, Vol. 20 No. 3, pp. 571-610.

Zucker, L.G. (1977), “The role of institutionalization in cultural persistence”, AmericanSociological Review, Vol. 42, pp. 726-43.

About the authorSuhaib Riaz (PhD, Richard Ivey School of Business, University of Western Ontario, Canada) is anAssistant Professor of Strategy at the University of Ontario Institute of Technology at Oshawa,Canada. His research interests include institutional embeddedness of key employees andorganizational capabilities, and organizational action and institutional change. Suhaib Riaz canbe contacted at: [email protected]


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New thinking on the financialcrisis

Roy E. Allen and Donald SnyderSaint Mary’s College of California, Moraga, California, USA

Abstract

Purpose – The purpose of this paper is to expand understanding of the current global financial crisisin light of other large-scale financial crises.

Design/methodology/approach – The phenomenon of large-scale financial crisis has not beenmodeled well by neo-classical general equilibrium approaches; the paper explores whetherevolutionary and complex systems approaches might be more useful. Previous empirical work andcurrent data are coalesced to identify fundamental drivers of the boom and bust phases of the currentcrisis.

Findings – Many features of financial crisis occur naturally in evolutionary and complex systems.The boom phase leading to this current crisis (early 1980s through 2006) and bust phase (2007-) areassociated with structural changes in institutions, technologies, monetary processes, i.e. changing“meso structures”. Increasingly, purely financial constructs and processes are dominantinfrastructures within the global economy.

Research limitations/implications – Rigorous analytical predictions of financial crisis variablesare at present not possible using evolutionary and complex systems approaches; however, suchsystems can be fruitfully studied through simulation methods and certain types of econometricmodeling.

Practical implications – Common patterns in large-scale financial crises might be betteranticipated and guarded against. Better money-liquidity supply decisions on the part of officialinstitutions might help prevent economy-wide money-liquidity crises from turning into systemicsolvency crises.

Originality/value – Scholars, policymakers, and practitioners might appreciate the morecomprehensive evolutionary and complex systems framework and see that it suggests a newpolitical economy of financial crisis. Despite a huge scholarly literature (organized recently as first-second- and third-generation models of financial crises) and a flurry of topical essays in recent months,systemic understanding has been lacking.

Keywords Recession, Financial markets, Money, Credit


1. IntroductionThe current global financial crisis has many patterns in common with other recentlarge-scale financial crises, including in developed countries (e.g. Finland and Swedenin 1991, Japan after 1989) and less developed countries (e.g. Latin America in 1982,Asia in 1997, Russia and Brazil in 1998, Argentina in 2002). Despite a huge historicalliterature on boom-bust processes, and despite a flurry of topical essays in recentmonths, some of these more important patterns are only now being identified.

Section 2 summarizes recent taxonomies with particular attention to the currentsituation. In order to describe the current crisis, first-, second-, and third-generationfinancial crisis models, which are found in the economics literature, are all helpful, butremain incomplete, especially in explaining “non-equilibrium” movements in exchangerates, interest rates, international investment flows, stock market and real estate



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values, and other key financial variables. Thus, as elaborated in Section 3, there is arevival of interest in psychological and social constructs, including what Keynes, inThe General Theory, called “animal spirits” and other behaviors that may occur ifpeople have a limited cognitive and informational basis for fully rationaldecision-making, and therefore, they may rely on less rational social conventions,vague beliefs, and other psychological factors.

1.1 What does this paper propose to contribute to this literature?First, in Section 4 key financial variables are, indeed, shown to be driven somewhatmore by subjective, even transcendental (of observable gross domestic product – GDP– or “real” processes) psychological and social constructs than is commonlyunderstood. Since the 1980s, structural changes in evolving financial markets,especially advances in information-processing technology and governmentderegulation, have allowed a greater separation of financial market processes fromGDP processes. Specifically, as per the econometric research of one of the authors, thedemand for money-liquidity for financial market participation has become – especiallyduring episodes of chaotic structural change – an important source of money demandwhich absorbs money-liquidity away from observable GDP uses. As a related process,monetary wealth can thus be created, transferred, and destroyed across time and spacemore powerfully and independently of observed GDP processes than is commonlyunderstood.

Second, as elaborated in Section 5, expanding our understanding of the currentcrisis can be assisted by evolutionary and complex systems approaches, especiallyones that privilege the role of interactive knowledge and belief systems. The relativerise and fall of interactive institutional and technological systems, or “meso” structuresin the language of evolutionary economics, are seen to play a key role in driving thecurrent boom-bust pattern. Transitions and imbalance between meso structures canaccount for long-run discontinuities or instabilities beyond what can be explained bynormal business cycle theory.

These conclusions are then summarized in Section 6 as they might direct us towarda new political economy of financial crisis.

2. Definitions and common patternsA “financial crisis” is generally defined to be “a wider range of disturbances, such assharp declines in asset prices, failures of large financial intermediaries, or disruption inforeign exchange markets” (De Bonis et al., 1999). There is a “crisis”, generallyspeaking, because the real economy is seriously and adversely affected, includingnegative impacts on employment, production, purchasing power, as well as thepossibility that large numbers of households and firms or governments arefundamentally unable to meet their obligations, i.e. “insolvency”. When anorganization is fundamentally solvent but temporarily unable to meet its financialobligations, then the notion of “illiquidity” is often used, but in practice insolvency andilliquidity are difficult to distinguish. For example, a common pattern is that “viciouscircles” start from a money-liquidity crisis at a few banks, which then extends to aninternational crisis of investor confidence in the financial sector, which extends to abalance of payments problem for the country and currency devaluation, which extendsto, therefore, even further liquidity and, at some point, solvency crises at the banks.

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Recent models of large-scale financial crises are often characterized as“first-generation” models or “second-generation” or, in the last few years,“third-generation”. First-generation models, as pioneered by Krugman (1979) andothers, emphasize the importance of a country’s foreign exchange reserves, i.e. ifgovernment budget deficits are excessive, then ultimately a government loses theability to maintain these reserves, and a speculative attack on its currency exchangerate is inevitable. Second-generation models, as summarized by Rangvid (2001), aroseduring the 1990s when this cause-effect linkage no longer explained various currencycrises. In particular, there is now a weaker relationship between economicfundamentals such as public sector deficits and the timing and severity ofspeculative currency attacks and related instabilities. The timing of governmentdecisions to abandon a currency regime in favor of other political-economic goals hasalso proved difficult to predict. Second-generation models thus tell stories of “multipleequilibrium” values that key variables might assume, unpredictable or irrationalbehavior by private investors and governments, and there has been an effort todiscover new “sunspot variables” that will better explain sudden changes in markets.

Third-generation models, as per Krugman (1999) and Allen et al. (2002), introduceadditional variables and feedback processes, especially the role of companies’,entrepreneurs’, and governments’ balance sheets, and the impact of internationalfinancial flows and exchange rates on those balance sheets. During and after the 1997Asian financial crises, the financial condition of firms weakened more than wasanticipated by second-generation models, which drew attention to these processes.Furthermore, until new entrepreneurs come forward, or until balance sheets return tonormal, it has been difficult for economies to return to normal growth and stability.

In most recent cases of large-scale financial crisis, a country or region initiallybenefits from expanded supplies of base money, new “quasi-moneys” which arecreated from base moneys, and credit supplies – a financial liberalization andderegulation phase. Typically the financial sector expands as it captures profit fromnew efficiencies and opportunities allowed by globalization. The country or region, fora time, may be favored by international investors; thus the banking system, includinggovernment, is well-capitalized and able to expand money-liquidity. Assets increase inmonetary value and interest rates are low, and this wealth effect encouragesconsumption, borrowing, business investment, and government spending. Productiveresources are more fully utilized and economic growth is well supported. There is a“boom”, as measured by increased monetary wealth held by private and public sectorsof an economy, such as the value of stocks, real estate, currency reserves, etc., and/orthe current production of merchandise and services (GDP).

Then, typically, the supply of base money (m) times its rate of circulation or velocityfor GDP purposes (v) contracts, and therefore so does the equivalent nominal GDP. Thedecline in nominal GDP is usually split between its two components:

(1) real GDP, which is the volume of current production measured in constantprices (q); and

(2) and the GDP price level ( p).

By definition, these variables are linked by the equation of exchange: (m £ v ¼ p £ q).When q declines for a sustained period (typically at least six months) we call it arecession, and when p declines we call it deflation. After this process starts, monetary

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policymakers may react by rapidly expanding (m), but this action may be too little toolate – individuals and institutions may have non-payable debts, banks may be failing,and international confidence in the country or region may already be damaged. In thispessimistic case, which is typical in less-developed countries with weak financialsystems, the desperate increase in m may reverse the slide in p and even lead tohyper-inflation (destabilizing, rapid increases in p), but q would continue to fall. Also, aweak financial system may be unable to maintain the circulation rate of securecurrencies for productive activities, especially if people are hoarding money, and thus vwould decline.

The initial contraction in “effective money” (m £ v) in a crisis may be caused bymonetary authorities or national and international investors draining money (m) fromthe country or region, or there may be a decline in v for reasons having to do with theinability of the financial system to direct money toward productive activities. Acontraction in effective money or withdrawal of international investment mayundermine equity markets, debt markets, bank capital, or government reserves, andmonetary wealth is then revalued downwards. General economic or politicaluncertainty worsens the situation – the resulting austerity-mentality causes acontraction of spending and credit, and an increased “risk premium” attached tobusiness activity scares away investment and bank lending. Interest rates rise, thedemand for quasi-money and credit – i.e. the desire to hold and use the insecure“monetary float” – declines and people try to convert the monetary float into moresecure base money, Treasury securities, and other more secure assets. Noreserve-currency banking system is able to cover all of its monetary float withsecure bank reserves if customers try to redeem too much of the float at once, and thus“runs” on banks can destroy the banks themselves. A deteriorating banking sectormay be unable to honor its deposits, bad loan problems surface and a “lender of lastresort” such as the central bank, taxpayers, or the International Monetary Fund (IMF)may need to be found.

How far do these common patterns go toward explaining the current globalfinancial crisis? The authors agree with many other commentators, such as Reinhartand Rogoff (2007), that the current crisis fits many historical patterns, as explainednext with emphasis on the US situation. In particular, Reinhart and Rogoff (2007) findthat:

. . . the run-up in US housing and equity prices that Kaminsky and Reinhart (1999) find to bethe best leading indicators of crisis in countries experiencing large capital inflows closelytracks the average of the previous 18 post-World War II banking crises in industrial countries(p. 339).

The initial financial liberalization and globalization boom phase of the current crisiswas driven in the early 1980s by widespread deregulation of financial markets in thedeveloped world especially the Reagan administration reforms in the USA and theThatcher administration reforms in the UK. These policies were guided by ideologiesand belief systems aimed at restoring a more capitalist tradition, and they eventuallyprevailed across the global system. French President Mitterrand’s attempt to advance amore socialist set of values and policies floundered by late 1982 and financial marketderegulation and international integration spread not only in Europe and NorthAmerica, but also Asia, Latin America, Africa, and Eastern Europe. Newly unregulatedfinancial products, entities and markets came to play a larger role. Also, dramatic


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advances in information-processing technology (electronic banking systems,communication satellites, the computer revolution, etc.) facilitated internationalarbitrage. The commoditization and securitization of financial products by the privatesector, including through virtually unregulated no-reserve-requirement “offshorebanking facilities” led to dramatic increases in international money liquidity andcredit, and by the end of the 1980s, global financial markets were generating a netinternational flow of funds of more than $3 trillion each month, i.e. the flow of fundsbetween countries that reconciles end of the month balance of payments accounts. Ofthat $3 trillion, $2 trillion was so-called stateless money, which was virtually beyondthe control of any government or official institution, but available for use by allcountries (Barron’s Magazine, 1987, p. 45).

This 1980-2006 boom phase of the current crisis was driven by fundamentalchanges in the basic social and technical rules of the game, or “meso” structure of theglobal economy (as per the evolutionary economics language of Section 5), which,among other characteristics, replaced more hierarchically organized,communitarian-disciplined, national-government-controlled rules with, instead, morefree-market, technologically innovative, decentralized, and chaotically-individualisticmeso structures as financial globalism prevailed.

As one of the authors has elaborated elsewhere (Allen, 1999), these structuralchanges associated with financial globalization supported an increasing net financialinflow from the rest of the world into the USA from near-balance in 1980 toapproximately $800 billion per year or 6 percent of GDP as a net financial inflow in2006 – the peak of the long boom – which supported classic-pattern excesses inlow-interest rate debt financing and spending, monetary wealth creation processes,consumerism and financial asset inflation, and now-famous lax standards in mortgagefinancing and securitization vehicles such as “collateralized debt obligations” and“structured investment vehicles” that passed the rights to the mortgage payments andrelated credit/default risk to third-party investors. The US household personal savingsrate dropped from 8 percent of disposable income to 0 percent over this 1980-2006period, while the “net wealth of the US” (net value of business assets, real estate,consumer durables, and US government property) increased from approximately $7trillion to $50 trillion in nominal terms.

The end of this long boom from the early 1980s to 2006, and the beginning of thecrisis or bust phase, began with the bursting of the US housing bubble and a sharp risein home foreclosures in the USA in late 2006, which spread to become a morebroad-based global financial crisis within a year. The mortgage lenders that retainedthe risk of payment default, such as Countrywide Financial, were the first financialinstitutions to be affected as borrowers defaulted. Major banks and other financialinstitutions reported losses of approximately $100 billion by the end of 2007. ByOctober 2007, 16 percent of subprime loans in the USA with variable interest ratefeatures were 90 days delinquent or in foreclosure proceedings, roughly triple the rateof 2005, and by January of 2008, this number increased to 21 percent.

Losses in the money-credit pyramid then began to spread across the systemincluding through the collapse in June 2007 of two hedge funds owned by Bear Stearnsthat were invested heavily in subprime mortgages. The lender-of-last-resort (LOLR)phase of the crisis began as the Federal Reserve took unprecedented steps to avoid aBear Stearns bankruptcy by assuming $30 billion in its liabilities and engineering thesale of Bear Stearns to JPMorgan Chase. In August 2008 the US Treasury (and

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therefore the US taxpayer) joined the LOLR phase by taking over and guaranteeing thefunding of Fannie Mae and Freddie Mac, the quasi-government housing marketentities. In September 2008 American International Group, because of its exposure tocredit default swaps, was bailed out by the Federal Reserve in an $85 billion deal, andthen later that month the US taxpayer-sponsored $700 billion bailout bill was passedafter Congress amended the plan to add more oversight, limits on executive pay, andthe option for the government to gain equity in the companies that it bails out. As inFinland and Sweden’s crises in 1991, Europe and the USA quickly moved to acquireequity stakes in, and partly nationalize, the banks.

As this essay is written in late 2008, the world thus moves quickly to regaincoordinated state “social market capitalism” control of the financial system, i.e. backtoward the pre-1980 “meso” rule structures that were more hierarchically organizedand communitarian-disciplined (by treasuries and central banks and other officialinstitutions) in place of the more free-market innovative, decentralized, andindividualistic rule structures that dominated between 1980 and 2008. In testimonybefore the US Congress on 23 October 2008, former US Federal Reserve Chairman AlanGreenspan famously said that “I made a mistake in presuming that the self-interest oforganizations, specifically banks and others, was such that they were best capable ofprotecting their own shareholders”.

3. The role of psychological and social factorsSecond- and now third-generation models of financial crisis, while simulating manycommon patterns, do not yet explain sudden movements in exchange rates, interestrates, international investment flows, stock market and real estate values, and otherkey variables to levels beyond normal fluctuations. Thus, there is a revival of interestin what Keynes, in The General Theory, called “animal spirits” such as “spontaneousoptimism” among entrepreneurs and others (Marchionatti, 1999). Essentially, Keynesargued that people may have a limited cognitive and informational basis for fullyrational decision-making, and therefore, they may rely on less rational socialconventions, vague beliefs, and other psychological factors. One implication is that:

. . . the market will be subject to waves of optimistic and pessimistic sentiment, which areunreasoning and yet in a sense legitimate where no solid basis exists for a reasonablecalculation (Keynes, 1936, p. 154).

As authoritatively summarized by Kindleberger (1989) in Manias, Panics, andCrashes: A History of Financial Crises, over the long history of market capitalism, thestart of an unsustainable financial boom or “mania” is always linked to a suddenincrease in money liquidity and lending. Unstable and exaggerated expectations,which are quite subjective, play a role:

The heart of this book is that the Keynesian theory is incomplete [in explaining economicinstabilities and crises], and not merely because it ignores the money supply. Monetarism isincomplete, too. A synthesis of Keynesianism and monetarism, such as the Hansen-HicksIS-LM curves that bring together the investment-saving (IS) and liquidity-money (LM)relationships, remains incomplete, even when it brings in production and prices (as does themost up-to-date macroeconomic analysis), if it leaves out the instability of expectations,speculation, and credit and the role of leveraged speculation in various assets (Kindleberger,1989, p. 25).


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Given the increased importance, across a larger and more dynamic global politicaleconomy, of subjective expectations, leveraged investment as supported by newelectronic and derivative money and credit forms, unregulated no-reserve-requirementoffshore financial markets, etc., some current research is consistent with the innovativenotion that monetary-wealth, or what Marx called “unproductive finance capital” (asopposed to physical capital or capital goods such as machines and factories) may be a“driver” of economic instabilities. As elaborated by Philip Cerny among others, the newglobal financial markets may even be an “infrastructure of the infrastructure”. Cerny’sinitial position, elaborated in debates that began in the early 1990s, was that “a countrywithout efficient and profitable financial markets and institutions will suffer multipledisadvantages in a more open world [. . .] [and will] attempt to free-ride on financialglobalization through increasing market liberalization” (Cerny, 1993, p. 338). Helleiner(1995) restrained this position – of a determinist, autonomous, technology-drivenfinancial globalization – by demonstrating that states, especially the USA and the UK,have fostered and guided the entire process.

Scholarly journals have been launched in recent decades to respond to these issues.For example, in the first edition of Review of International Political Economy, theeditors state:

The creation of a global economic order has come to represent the defining feature of our age,as a major force shaping economies and livelihoods in all areas of the world. Globalization, ofcourse, has many aspects [. . .] The first of these is the emergence of a truly global financialmarket [. . .] and the resulting increase in the power of finance over production (Review ofInternational Political Economy, 1994, p. 3).

Reversing the causality of Karl Marx’s (and many others’) philosophical materialism, itmay increasingly be true that autonomous, invisible financial processes can drivechanges in the physical relations of production, as well as vice versa. As part of thisprocess, central banks and other financial market participants can (usuallyhaphazardly) increase or reduce wealth independently of any initial changes in theproduction of GDP or other “real” economic prospects. The Chairman of the US FederalReserve, Alan Greenspan, began allowing for this possibility in the late 1990s:

Today’s central banks have the capability of creating or destroying unlimited supplies ofmoney and credit [. . .]. It is probably fair to say that the very efficiency of global financialmarkets, engendered by the rapid proliferation of financial products, also has the capability oftransmitting mistakes at a far faster pace throughout the financial system in ways that wereunknown a generation ago, and not even remotely imagined in the 19th century [. . .]. Clearly,not only has the productivity of global finance increased markedly, but so, obviously, has theability to generate losses at a previously inconceivable rate (Greenspan, 1998).

The authors would emphasize from Greenspan’s quote that “the capability of creatingor destroying unlimited supplies of money and credit” is equivalent to “the capabilityof creating or destroying monetary wealth”. Money and credit are “stores of value”, asdetermined by social consensus within nations and between nations.

Transcendental notions of value applied to monetary assets need not reflect, or evenbe compatible with, the observed empirical world. For example, the purelytranscendental “law of compound interest” is a social agreement, which may notcorrelate with the way that the physical economy grows. Growth in the physicaleconomy is subject to thermodynamics, biological growth processes and carrying

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capacity, endowments of resources, sunlight and rain, etc. Perhaps debtors as a group,who are required to pay exponentially increasing interest under this transcendentallaw, can generate goods and services and therefore economic revenues only inarithmetically increasing increments over time. Therefore, perhaps some debtors haveto fail, and yield their economic resources to the others, so that the others can meet theirobligations.

Invisible belief systems, including those of money-gamblers and optimistic marketcapitalists, have supported a money economy based on exponential interest payments,and an easing of lending restrictions. The acceptance and growth of offshore finance inthe 1980s and 1990s, without reserve requirements or other significant regulations, isan example of how belief systems – in this case market capitalist ideology — driveinstitutional change. Offshore market institutions, such as the Bangkok InternationalBanking Facility, encouraged unsustainable over-lending, excessive unprofitableconstruction of real estate, etc., and ultimately contributed to the risk of crisis,recession and misery in the Asian financial crisis of 1997. Belief systems and theirsupporting institutions can thus drive empirical changes in human populations andtheir physical environments. Much of the economic wealth that was initially createdthrough deposit-lending, as it exercised itself in production power, consumption power,and power to change institutions, was destroyed in the recent Asian crisis, but itnevertheless did exist as a broad social agreement.

Whether or not financial crises arising from over-indebtedness and deflation – asper Irving Fisher’s classic work (Fisher, 1933) – should be systemically expected inmodern capitalism has been debated. Mainstream economic thinking has until recentlybeen generally confident that “hard-to-qualify” lending-restrictions, wherein all partiesare conscious of systemic risk, can avoid over-lending and debt-failure. In contrast,Marxists (see Clarke, 1994) and others across various disciplines, such as FrederickSoddy (1926), are convinced that these crises are endemic to capitalism. Most recently,as summarized by Reinhart and Rogoff (2008), a new data set covering eight centuriesand 68 countries shows “a perennial problem of serial default [. . .] in this respect the2007-08 US sub-prime financial crisis is hardly exceptional” (p. 2).

Given that massive debt-repudiation crises continue to happen in the world system,we have not yet been able to avoid over-lending and periodic disjuncture-crisesbetween, on the one hand, the belief system which includes mathematical compoundinterest, and on the other hand, the ability to generate money from tangible “realworld” processes. Some borrowers and lenders are well informed but recklessrisk-takers who know that periodic failures are required in “casino capitalism” (JohnMaynard Keynes’s phrase), whereas other borrowers and lenders underestimatesystemic risk and allow over-lending based upon a mistaken ideology regarding thestability of the system. Thus, on both accounts, the literature generally concludes thatdebt crises are likely to remain with us.

4. New thinking4.1 What do the authors propose to contribute to this literature?First, in the authors’ view, key financial variables can be driven somewhat more bysubjective, even transcendental (of observable GDP or “real sector” processes)psychological and social constructs than is commonly understood. Consequently, therehas been an even greater separation of financial market processes from GDP processesthan is commonly understood. And, monetary wealth has thus been created,


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transferred, and destroyed across time and space more powerfully and moreindependently of observed GDP processes.

Second, a better understanding of the current crisis can be assisted by evolutionaryand complex systems approaches (as elaborated in Section 5), especially ones thatprivilege the role of interactive knowledge and belief systems and the psychologicaland social factors discussed above.

The econometric work of one of the authors (Allen, 1989, 1999) supports this “newthinking” – essentially by showing that, under certain conditions, financial marketscan “absorb” a portion of the money supply, such that the absorbed money is notcontemporaneously available to support and induce the “real economy”. Whileeconomic literature has examined various demands for money for financial marketparticipation, the author’s contribution to that literature was the first to show that theabsorbed money was not simultaneously available even to induce or incentivize GDPactivity. This absorption shows up as a decline in the GDP-velocity of narrow money(v), ceteris paribus, and it can also be measured by a divergence in the growth of broadmoney supply aggregates (such as M3) relative to narrow money supply (such as M1),ceteris paribus. This absorbed money-power might be used at a later date to reengageGDP production or consumption, or it might be destroyed in a financial crisis before itstitle-holders can use it. Therefore, money is not a neutral driver of the real economyover time. Furthermore, this absorption process can occur to facilitate the boom phaseof a financial crisis cycle, and it can also facilitate the bust phase – by driving assetvalues beyond normal or sustainable levels.

For example, Figure 1 shows a structural decline in the long-term trend GDPvelocity of money (v) in the USA, the UK, and Canada in the early 1980s thatcorresponded with the beginning of the boom phase of this current financial crisis. Ineach of these countries, corresponding with the particular timing of the break in v,governments dramatically abandoned financial market protectionism. Policymakersremoved ceilings on interest rates, reduced taxes and brokerage commissions onfinancial transactions, gave foreign financial firms greater access to the home financialmarkets, allowed increased privatization and securitization of assets, and took othersteps that allowed money to move more freely and profitably between internationaland national markets. As can be seen in Figures 2 and 3 for the USA and the UK, inthese key “phase shift” years, there was a corresponding dramatic expansion in thetransactions volumes of money-absorbing financial transactions (measured as thecombined value of stock, bond, and government securities transactions) – shown as aninverse relationship between v and financial transactions volumes. In the USA, themajor structural break in v along with other monetary-transmission relationships

Figure 1.Structural declines in theincome (GDP) velocity ofmoney in the 1980s:identifying the start of thecurrent financial boom(Source: IMF)

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occurred in 1982 as participants responded to newly profitable forms of liberalizedfinancial market participation with the aid of new information processing technologies(Allen, 1989, p. 273). The major structural break in the UK occurred in 1985-1986 asparticipants anticipated the UK’s “big bang” of October 1986, which ended fixedcommissions for brokers and separation of powers between brokers, and allowed arush of foreign financial firms into the marketing of British stocks and governmentbonds and other securities.

In addition to the direct absorption of money away from GDP activity to accommodatetransactions demands for exploding volumes of financial activity, a related form ofabsorption occurred in the UK case due to uncertainty or information failure experiencedby holders of money. That is, during a dramatic upheaval or structural change as per BigBang, financial portfolios must be reallocated dramatically as the new opportunities arefigured out and reacted to. For a time, there is not sufficient information for investors topursue rational strategies, and the price of money-liquidity rises sharply. An increase inmoney demand occurs to reduce the risk of loss and in order to regain an optimal portfolioquickly once the information environment improves.

In the authors’ view, this “options demand” for money can divert money-liquidityaway from GDP and other markets during chaotic times (once again such that GDPactivity is neither accommodated or incentivized by this portion of the money supply –

Figure 2.Expanding volumes of

money-absorbing financialtransactions in the USA

($trillion/year) and the USincome velocity of money

(M1)

Figure 3.Expanding volumes of

money-absorbing financialtransactions in the UK

(million of pounds/year)and the UK income

velocity of money (M1)


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the “new” claim of the authors), but it is not generally recognized by the economicsprofession. However, many securities market professionals swear by it. For example,Joseph Grundfest, former Commissioner of the US Securities and ExchangeCommission, explained the 1987 world stock market crash as follows:

Simply put, I suggest that a large component of recent market volatility is the rational resultof an “information failure” in the market for liquidity rather than the consequence of rapidand irrational changes in the market’s assessment of the value of securities [. . .] The lack ofinformation about either fundamental business prospects or about the magnitude andcomposition of an atypically large demand for immediate trading can be sufficient to inducesubstantial market volatility [. . .] [A] sharp increase in the price of liquidity is reflected in asimultaneous widening of spreads and in a general price decline in the equities and futuresmarket alike [. . .] Once sufficient information comes to the market describing expectedshort-term trading flows, and once the returns to providing liquidity become high enough, thepeak-load nature of the demand subsides, the risk involved in trading is reduced, the price ofliquidity declines, spreads narrow, and equity prices recover a large portion of their losses(Grundfest, 1991, p. 67-8).

Japan’s financial crisis, which saw 50 percent declines in stock market prices along withsimilar declines in real estate and other asset prices after 1989, shows how this moneyabsorption can occur in the bust phase of a financial crisis. Namely, absorption of basemoney by financial markets and therefore a decline in its rate of circulation for GDPpurposes (v), in times of financial distress, can also be measured by a weakness in thegrowth of broad money. Expanded supplies of high-powered money may not be able toserve as a base for expanded supplies of broad money if the high-powered moneysupplies are instead consumed by financial institutions to resolve bankruptcies, increasereserves, and meet other capital requirements. In this case, a decline in broad moneywould correspond to a decline in the velocity of high-powered money as it is absorbed bydistressed financial markets rather than being used to support growth in GDP.

Japan’s narrow (M1) velocity began dropping significantly in the early 1990s – byapproximately 30 percent from a value of 3.5 ( ¼ nominal GDP divided by M1) in 1990to 2.5 in 1995. Just as dramatically, Figure 4 shows the big decline in the growth ofJapan’s broad money supply (M2 þ CDs) in the 1990s which correlated with declines in

Figure 4.Japan’s financial crisis.The dramatic decline inJapan’s broad moneysupply growth rate(M2 þ CDs) in the 1990swas correlated withdeclines in the stockmarket, real estate values,and real GDP

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the stock market, real estate values, and real GDP (in July 1998 a GDP recession beganbut was mostly avoided). Maintaining the growth of the narrow money supply (M1) didnot prevent deflation and recessionary conditions, because more of the M1 wasabsorbed by distressed financial institutions. Elaborating this situation further,research in 1998 indicated that:

A central bank in a deflationary situation with troubled banks must avoid interpreting low[nominal] interest rates as an indicator of an expansionary policy. When monetary growth islow and default risks are high as in Japan today, low interest rates reflect expectations of bothlow (or negative) inflation and rates of return. In such a situation, the appropriate focus ofmonetary policy is on money and not interest rates [broad money supplies should be expandeddespite low interest rates] (Federal Reserve Bank of St Louis, 1998, p. 1).

The current global financial crisis mirrors many aspects of Japan’s crisis after 1989.Developed-country stock markets are down close to 50 per cent from their peak, realestate prices, as they did in Japan, are falling more slowly but on the same trajectory(currently down 20 per cent from their peak), expanded ‘rescue’ supplies ofhigh-powered money are not yet serving as a base for expanded supplies of broadmoney as the high-powered money supplies are instead consumed by financialinstitutions to resolve bankruptcies, increase reserves, and meet other capital goals inan environment of uncertainty and information failure. There is a decline in the incomevelocity of narrow money supplies and recession and the risk of deflation in the realsector are imminent.

Although the US Federal Reserve took the controversial decision to stop reportingbroad US money supply M3 data (supplies of cash and a wide range of bankinstruments) in 2005 on the grounds that the modern financial system made this dataunmanageable and not useful, estimates compiled by Lombard Street Research show adecline in the US M3 growth rate from 19 percent in early 2008 to 2.1 percent(annualized) in the period May-June 2008 – a decline very similar to Japan’s M2 þ CDdecline in 1991-1992 as shown in Figure 4. A continuing decline in estimated US M3 inJuly 2008 by $50 billion was the biggest one-month fall of US. M3 since modern recordsbegan in 1959. The US M1 growth rate, which had fluctuated around 0 percent during2006 and 2007 and the first half of 2008, was dramatically increased by the FederalReserve (too little too late in the view of the authors) to approximately 5 percent inSeptember 2008 (and thus it has not served as a base for expanded supplies of broadmoney as these supplies are instead consumed by financial institutions in distress). Asthis article is written, with nominal GDP declining from trend, the recent 5 percentincrease in the growth rate of US M1 translates into a greater than 5 percent structuraldecline in the US income velocity of money (M1).

What will prove interesting to estimate, when a few more quarters of GDP data areavailable, is whether the econometric equations (Allen, 1989, 1999) that measured theshare of narrow money supplies contemporaneously absorbed for financial purposes inthe boom phase of the 1980s is similar to the share of narrow money supplies absorbedfor financial purposes in this bust phase. Also to be encouraged is research on whethertypical boom and bust phase money absorption magnitudes across various large-scalecountry crises have been similar – thus supporting better money-liquidity supplydecisions on the part of central banks and official institutions that might help preventliquidity crises from turning into solvency crises.


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5. Evolutionary and complex systems approaches toward understandingthe current crisis5.1 Mainstream economic theory and financial crisesThe neoclassical general equilibrium model has long provided the theoretical rationaleunderlying mainstream economic efforts to understand macroeconomic fluctuations.This model conceives of an economy as a set of fully connected interlocking marketswhich can be analyzed like a force field in physics. To make the model work it isvirtually imperative to assume that the market participants are homogeneous or nearlyso. Prices in this model are not negotiated, they are set by a central authority (thefamous Walrasian auctioneer) who assesses prevailing excess demands and imposes aset of prices that will clear all markets simultaneously. The model presumes strongtendencies towards equilibrium: it would be in equilibrium most of the time unlesssome exogenous force was to disturb it, in which case it would normally settle backquickly. But nominal and institutional rigidities are assumed to prevent such shocksfrom being perfectly damped, which generates business fluctuations.

Markets in a model like this satisfy the efficient markets hypothesis and, (because ofthe strong equilibrium tendencies), have price changes that are Gaussian (normally)distributed. An important feature of a Gaussian distribution is that very large positiveand very large negative deviations from the mean (more than three standarddeviations, say) are virtually impossible. Yet price changes of these magnitudesroutinely occur during financial crises. This suggests that whatever is occurringduring these episodes is not following the processes embodied in the generalequilibrium model.

The general equilibrium model also assumes that promises are always fulfilled:when goods are purchased or loans are made, the goods get paid for and the loans getrepaid on schedule. This condition is routinely violated in a financial crisis.Leijonhufvud (2004) notes that, despite the obvious importance of understanding bettersuch breakdowns in the equilibrating processes, which can threaten the social order,modern macroeconomics sheds little light on their nature. LeRoy (2004), in his surveyof traditional economic analyses of price bubbles, comes to a similar conclusion.

5.2 Complexity theoryGiven the inability of standard general equilibrium theory to explain the occurrence offinancial bubbles and crises, researchers have explored other avenues. One promisingapproach is to look at the economic system through the lens of complexity theory. Acomplex system differs in important ways from the general equilibrium system ofneoclassical economics. If an economy is a complex system, all behavior emanates fromthe bottom, from the actions of individual agents: there is no global controller orauctioneer to set parameters or behavior. Because agent behaviors interact in nonlinearways, the macro result which emerges can have a life of its own which is not obviouslydeducible from the properties of the agents: the whole is not only greater than the sumof the parts, it is different as well. Positive feedback loops often exist, which amplifythe effects of small changes into large cascades with significant influence. Complexsystems are path-dependent, meaning that their present state is determined by whathappened to them in the past (history matters). They exhibit perpetual novelty: newbehaviors and structures constantly stimulate more of the same. Dynamics dominatesstatics; the system evolves and adapts rather than just “running” as generalequilibrium models tend to do. As a consequence, a complex system is rarely in

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equilibrium. It may have long periods of stability, but stability is not the sameas equilibrium: it can degenerate into chaotic behavior at short notice withoutexogenous disturbance. This often signals what is known as a phase shift, whereby thesystem changes from one way of functioning to a distinctly different way. Financialcrises can often be thought of as phase shifts.

Because a complex system does not have strong tendencies to equilibrium, it doesnot usually generate variables with Gaussian distributions. Instead, it tends to producepower law distributions, which have fatter tails than the Gaussian and thus explain thefrequent occurrence of extreme positive and negative values. Benoit Mandelbrot(Mandelbrot and Hudson, 2004) has been a student of financial system prices for manydecades and has produced persuasive evidence that they follow power lawdistributions. His work, long ignored and even suppressed by efficient markettheorists, is now widely recognized as correct and has been brought to the attention ofthe general public by Nassim Taleb (2007).

5.3 Complex adaptive systemsThe mathematics of complex systems has been studied for some time now and isreasonably well understood. Although phase shifts and cascades are suggestive offinancial crises and power laws are consistent with frequent large price changes,complex systems were originally developed to explain inanimate phenomena such aschemical reactions. The agents in that type of complex system have no volition of theirown: they passively respond to whatever natural forces affect them. An economy onthe other hand is composed of agents who both perceive their situation and are capableof changing their behavior in response to it. This suggests the notion of a complexadaptive system (CAS) in which the agents are active participants. The behavior of aCAS is much more difficult to study, yet reflection suggests that a modern economy isalmost surely a CAS, so this is a task which must be undertaken if we are to makeprogress understanding financial crises.

Foster (2005) has developed a useful taxonomy for complexity systems. Heidentifies four types:

(1) First-order (imposed energy) – Found in inanimate settings when energy isimposed on chemical elements. Characterized by fractal patterns, butterflyeffects, etc. Can be modeled with dynamical mathematics. This is the approachMandelbrot applied to financial prices. The agents react passively, so this is acomplex system.

(2) Second-order (imposed knowledge, acquired energy) – Found in organicsettings. Plants and animals receive imposed (genetically encoded) knowledgeand also gain knowledge from experience. All of this gets translated into aknowledge structure that permits some control over energy acquisition. Agentsboth react and adapt to their environment, so this is a CAS.

(3) Third-order (acquired knowledge) – Agents interact not only with theirenvironment but also with images of possible worlds, i.e. mental models. Whenthis happens, some mental models will wind up determining aspects of reality.This is a CAS where “adaptive” involves creativity. If everyone has a mentalmodel of the market and begins associating with their fellow agents accordingto market rules, the market gets transformed from mental model into reality.


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(4) Fourth-order (interactive knowledge) – At this stage mental models beganinteracting with each other. Agents imagine what other agents might beimagining and alter their own models accordingly in a potentially infiniteregression. Agents form aspirations and commitments into the future. This typeof CAS gets extremely complicated and depends heavily on trust andunderstanding to achieve the cooperation necessary for the system to function.

In the study of financial crises, the first-order type of complex system is of interestbecause it provides realistic description of how prices behave in bubbles and panics.However, it gives us a little in the way of a behavioral explanation for these pricechanges. The fourth-order type does provide a basis for the behavioral explanation weseek. The problem is that fourth-order complex systems cannot at present be analyzedmathematically. However, though analytical solutions are at present not possible, suchsystems can be fruitfully studied through simulation methods and through certaintypes of econometric modeling, as detailed below.

The Federal Reserve has become interested in a complex adaptive systemsapproach to managing financial crises. In the world at large, complex systems abound– weather patterns, tectonic processes, disease contagion, power grids, etc. Theirinstability and potential for large, disruptive regime shifts are major social concerns.The ubiquity of such problems suggests that there may be common principles at work.A 2006 Federal Reserve conference on systemic risk (Kambhu et al., 2007) saw expertsfrom fields such a civil engineering, disease control, ecology, national security, andfinance discuss their approaches to catastrophe control. The following compositepicture emerged: an initial shock (possibly a seemingly insignificant one) leads to acoordinated behavior in the system with reinforcing (positive) feedbacks. A contagionbegins, which spreads the original shock. When the pressure becomes too much thesystem makes a regime shift “from a stable state to an inferior stable state whileshedding energy so that it cannot readily recover its original state, a process known ashysteresis” (Kambhu et al., 2007, p. 7). Research is focusing on factors that increaseresistance to regime shifts and hysteresis, and on factors than can help the systemrecover. Some of this research may prove helpful in managing financial crises.

5.4 Evolutionary economicsIf an economy is a complex adaptive system, then as time passes it does not just runlike an electric motor; its form and structure evolves. The machine is the metaphor ofthe general equilibrium economy; for the complex adaptive system economy, themetaphor is the living organism. It is not easy to model an evolving economy using theneoclassical model, which can accommodate growth fairly readily but structuralchange only with great difficulty. In a neoclassical model of an evolving economybased on past history, the parameter values are always becoming obsolete – slowlyand steadily sometimes, or very quickly when there is a structural shift.

The field of evolutionary economics has emphasized these issues for some time andhas made efforts to incorporate capacity for structural change into its models.Schumpeter’s idea that creative destruction is the essence of capitalism forms the basisof much modern thinking in evolutionary economics. Schumpeter emphasized the roleof liberal credit as a driver of speculative booms, and sudden credit contraction as amajor contributor to the severity of the ensuing crash (Leathers and Raines, 2004). Theversion of evolutionary economics which appears most useful for analyzing financial

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crises is the “Micro-Meso-Macro” framework of Dopfer et al. (2004). This frameworkcenters on two novel concepts:

(1) rules; and

(2) meso units.

A rule is a pattern that agents follow in their everyday economic behavior: it may becognitive, behavioral, technological, institutional, organizational, sociocultural, etc.Rules may be nested in other rules: we might talk about a motorcycle rule that includesengine rules, tire rules, etc. or a market rule that includes a double auction rule, afixed-price rule, etc. Rules are carried out (actualized) by microeconomic agents(individuals, families, organizations, etc.). A meso unit is a rule plus its population ofactualizations (e.g. the motorcycle meso is the motorcycle rule plus all agents whomake, sell, repair, or drive motorcycles). An economic system (assumed to be complexadaptive) is a collection of meso units evolving over time. Macroeconomic behavior isthe result of interactions among meso units. Economic evolution is the process bywhich new rules originate and diffuse through the population: very often this processtakes the form of a logistic growth path in the new rule’s meso unit. Structural changeoccurs when a new meso rule permanently alters the coordination structure of the mesounits of the economic system. Over time, creative destruction occurs: new rules areconstantly being originated; the successful ones develop strong mesos which displacepreviously dominant mesos; the weak ones disappear.

In this framework, a bubble or crisis in the financial sector would be analyzed as astructural change. Foster and Wild (1999b) have developed a promising econometricmethodology for analyzing such structural shifts in terms of the logistic function, andfor identifying early warning signals that the macro economy may be about to undergoa structural change. A high priority today is to analyze the international growth ofmoney and credit over recent decades using these techniques.

6. Conclusion: toward a new political economy of financial crisisThis paper has characterized the current financial crisis as having a long “boom” phase(early 1980s-2006), followed by a turning point and continuing “bust” phase (2007-)with many patterns in common relative to other financial crises. It is beyond the scopeof this paper to model this financial crisis rigorously; instead the goal has been tosuggest the best analytical framework – some of which is “new” as applied to financialcrises – that might direct more rigorous modeling.

Departing from the neoclassical general equilibrium model and other mainstreamapproaches, this paper proposes an evolutionary and complex systems approachtoward understanding the current crisis (as well as to rethink other large-scale crises).The 1980s boom in leveraged financial transactions was thus a ‘phase shift’ in acomplex adaptive system, and it was a transition to a new ‘meso structure’ in thelanguage of evolutionary economics. As the econometric research of one of the authorshas verified, structural changes in normal money supply and demand relationshipsoccurred in the USA, the UK, and other money centers at this time that were associatedwith government deregulation, advances in information-processing technology, andother aspects of financial liberalization and globalization (Allen, 1999). Althoughbeyond the scope of this paper to simulate rigorously, most of the trajectories offinancial market data associated with this crisis time period – as per Figures 1-4 – fit


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the patterns identified by Foster and Wild (1999a, p. 754) as “logistic diffusiontrajectories” with three self-organizing phases called the “emergent”, “inflexion”, and“saturation” phases.

As a result of these structural changes, financial markets absorbed newly-createdmoney-power beyond levels predicted by general equilibrium models, which in turnwere used to inflate asset prices and incentivize production or consumption beyondpredictions; then, during the bust phase, these variables moved in the oppositedirection more than expected including a greater than expected fall in stock and realestate prices and destruction of monetary wealth.

Depending on the magnitudes of these transfers and re-valuations of monetarywealth over (how much) time and space in the global system, serious real effects can beproduced over time and space. These processes, generally not accepted by mainstream,Marxist, and many other economists, can nevertheless account for what themainstream has understood as “business cycles”, “debt-deflation crises” includingdepressions (Fisher, 1933), etc., and what Marxists have understood as crises of“underconsumption”, “overproduction”, and ‘disproportionality’ (Clarke, 1994). Theideologies and institutions of finance, are not only “where the action is” and wheredifferential economic power is determined across the world system, but theseinstitutions are also increasingly key to the sustainability of the current globaleconomic system – a necessary “infrastructure of the infrastructure”, as per Cerny’s(1993) analysis.

This expansion and globalization of financial markets that accelerated in the 1980s,which seemed to take on a dramatic life of its own somewhat separate from GDPprocesses, can be modeled with the help of third-order and fourth-order complexityprocesses – acquired knowledge and interactive knowledge processes, respectively –as discussed in the previous section. Given the “animal spirits” of irrational exuberanceor fear, transcendental “laws of compound interest” and no-reserve-requirementmoney-liquidity creation, etc., interactive mental models drove financial cycles andmonetary wealth creation and destruction processes beyond the bounds of generalequilibrium to levels that required a breakdown in the equilibrating processes – theboom phase and its accompanying meso structure were unsustainable (beyond 2006 orso), and now a new meso structure is in process of adaptation.

In the new ordering of the global economy, it should be accepted that, increasingly,autonomous, invisible financial processes can drive changes in the physical relations ofproduction, rather than vice versa. As part of this process, central banks and otherfinancial market participants such as offshore banks can in some cases (haphazardly)increase or reduce wealth independently of any initial changes in the production ofGDP or other “real” economic prospects. And, this wealth – literally created or destroyedout of thin air (or cyberspace) in some cases – is generally allocated through the arbitrarycustoms and interest rates concessions of particular social networks. Wealth itself in theglobal human ecology, in these cases, can thus be derived entirely from “pure socialagreement”, depending on how well one can participate in the financial system.

A review of the authors’ controversial position as italicized here, especiallycritiquing it from the Marxist and other philosophical-materialist frameworks,appeared in Review of International Political Economy (1996). To the reviewer, theauthors’ approach incorrectly “privileges financial changes vis-a-vis changes in the realeconomy (production of value)” (p. 532). Furthermore, to the reviewer, any perceivedinitial creation and distribution of wealth or “value” that happens in “the thin air” of

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financial markets could not be sustained over time without correspondence tosupportive GDP activity.

In contrast, to the authors, “money is wealth” in the sense that it gives the holder aclaim on the entire social product. The “social product” includes not only consumptionpower and production power, but also the power to direct and control large socialprocesses – such as those that are dependent on (gaining access to) the institutions ofgovernment, courts, communications, and so on. The accumulation of monetary assets,or what Marxists would call the accumulation of finance capital, represents a socialpower claim that becomes a key driver in the evolution of the world system. Oncemonetary wealth is understood as power claims over the social product, then monetarywealth is “real”, and it is limited only by the degree to which power can be exerted overothers. Presumably this limit would only be found in the unlikely event that anall-encompassing global monopoly has maximized its differential power.

Recent research in the field of international political economy also treats monetarywealth, or finance capital (as opposed to physical capital or capital goods such asmachines and factories) as an accumulation of broad social powers:

Drawing on the institutional frameworks of Veblen and Mumford, our principal contributionis to integrate power into the definition of capital. Briefly, the value of capital representsdiscounted expected earnings. Some of these earnings could be associated with theproductivity (or exploitation) of the owned industrial apparatus, but this is only part of thestory. As capitalism grows in complexity, the earnings of any given business concern come todepend less on its own industrial undertakings and more on the community’s overallproductivity. In this sense, the value of capital represents a distributional claim. This claim ismanifested partly through ownership, but more broadly through the whole spectrum of socialpower. Moreover, power is not only a means of accumulation, but also its most fundamentalend. For the absentee owner, the purpose is not to “maximize” profits but to “beat theaverage”. The ultimate goal of business is not hedonic pleasure, but differential gain. In ourview, this differential aspect of accumulation offers a promising avenue for putting powerinto the definition of capital [. . .]. In the eyes of a modern investor, capital means a capitalizedearning capacity. It consists not of the owned factories, mines, aeroplanes or retailestablishments, but of the present value of profits expected to be earned by force of suchownership (Nitzan, 1998, pp. 173, 182).

Building on this quote, Nitzan argues that wealth accumulation processes allowed bymonetary capital have favored pecuniary business activities and owners over tangibleindustrial productivity and working consumers. He argues that, increasingly, “thecausal link runs not from the creation of earnings to the right of ownership, but fromthe right of ownership to the appropriation of earnings” (p. 180). This causality isconsistent with the writings of Thorstein Veblen, who insisted that the “natural rightof ownership” conferred by society to various people (initially to own slaves, thenanimals, land, and now capital including ever more symbolic monetary forms), can beused competitively to obtain further social powers at the expense of others (Veblen,1923).

To summarize, based upon these issues and frameworks, the authors and othersgradually propose “a new political economy of financial crises” (Allen, 2004) – aproject that is bound to gain further thrust both conceptually and empirically asanalysis of the current crisis proceeds. In the language of evolutionary economics,hopefully this essay has usefully described some of the path-dependent trajectory ofthis ongoing scholarly project – itself a “meso structure”.


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References

Allen, M., Rosenberg, C., Keller, C., Setser, B. and Roubini, N. (2002), “A balance sheet approachto financial crisis”, Working Paper No. 02/210, International Monetary Fund, Washington,DC.

Allen, R.E. (1989), “Globalization of the US financial markets: the new structure for monetarypolicy”, International Economics and Financial Markets: The AMEX Bank Review PrizeEssays, Oxford University Press, Oxford.

Allen, R.E. (1999), Financial Crises and Recession in the Global Economy, 2nd ed., Edward Elgar,Cheltenham/Northampton, MA.

Allen, R.E. (Ed.) (2004), The Political Economy of Financial Crisis, Edward Elgar,Cheltenham/Northampton, MA.

Barron’s Magazine (1987), “The globalization of the industrialized economies”, Barron’s, May 4.

Cerny, P.G. (1993), “The political economy of international finance”, in Cerny, P.G. (Ed.), Financeand World Politics, Edward Elgar, Aldershot/Brookfield, VT, pp. 3-19.

Clarke, S. (1994), Marx’s Theory of Crisis, St Martin’s Press, New York, NY.

De Bonis, R., Giustiniani, A. and Gomel, G. (1999), “Crises and bail-outs of banks and countries:linkages, analogies, and differences”, World Economy, Vol. 22 No. 1, pp. 55-86.

Dopfer, K., Foster, J. and Potts, J. (2004), “Micro, meso, macro”, Journal of EvolutionaryEconomics, Vol. 14, pp. 263-79.

Fisher, I. (1933), “The debt-deflation theory of great depressions”, Econometrica, Vol. I, pp. 337-57.

Foster, J. (2005), “From simplistic to complex systems in economics”, Cambridge Journal ofEconomics, Vol. 29, pp. 873-92.

Foster, J. and Wild, P. (1999a), “Detecting self-organizational change in economic processesexhibiting logistic growth”, Journal of Evolutionary Economics, Vol. 9, pp. 109-33.

Foster, J. and Wild, P. (1999b), “Econometric modeling in the presence of evolutionary change”,Cambridge Journal of Economics, Vol. 23, pp. 749-70.

Greenspan, A. (1998), “The globalization of finance”, Cato Journal, Vol. 17 No. 3, pp. 243-56.

Federal Reserve Bank of St Louis (1998), International Economic Trends, August.

Grundfest, J.A. (1991), “When markets crash: the consequences of information failure in themarket for liquidity”, in Feldstein, M. (Ed.), The Risk of Economic Crisis, The University ofChicago Press, Chicago, IL.

Helleiner, E. (1995), “Explaining the globalization of financial markets: bringing states back in”,Review of International Political Economy, Vol. 2 No. 2, pp. 315-41.

Kambhu, J., Weidman, S. and Krishnan, N. (2007), New Directions for Understanding SystemicRisk: A Report on a Conference Co-sponsored by the Federal Reserve Bank of New York andthe National Academy of Sciences, National Academies Press, Washington, DC.

Kaminsky, G.L. and Reinhart, C.M. (1999), “The twin crises: the causes of banking and balance ofpayments problems”, American Economic Review, Vol. 89 No. 3, pp. 473-500.

Keynes, J.M. (1936), The General Theory of Employment, Interest, and Money, Macmillan,London.

Kindleberger, C.P. (1989), Manias, Panics, and Crashes: A History of Financial Crises,Basic Books, New York, NY.

Krugman, P. (1979), “A model of balance-of-payment crises”, International Tax and PublicFinance, Vol. 6 No. 4, pp. 459-72.

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Krugman, P. (1999), “Balance sheets, the transfer problem and financial crises”, Journal ofMoney, Credit, and Banking, Vol. 11, pp. 311-25.

LeRoy, S.F. (2004), “Rational exuberance”, Journal of Economic Literature, Vol. XLII, September,pp. 801-3.

Leathers, C.G. and Raines, J.P. (2004), “The Schumpeterian role of financial innovations in thenew economy’s business cycle”, Cambridge Journal of Economics, Vol. 28 No. 5, pp. 667-81.

Leijonhufvud, A. (2004), “Celebrating Ned”, Journal of Economic Literature, Vol. XLII, pp. 820-1.

Mandelbrot, B. and Hudson, R. (2004), The Misbehavior of Markets, Basic Books, New York, NY.

Marchionatti, R. (1999), “On Keynes’ animal spirits”, Kyklos, Vol. 52 No. 3, pp. 415-39.

Nitzan, J. (1998), “Differential accumulation: towards a new political economy of capital”, Reviewof International Political Economy, Vol. 5 No. 2, Summer.

Rangvid, J. (2001), “Second generation models of currency crises”, Journal of Economic Surveys,Vol. 15 No. 5, pp. 613-46.

Reinhart, C.M. and Rogoff, K.S. (2007), “Is the 2007 US sub-prime financial crisis so different?An international historical pattern”, American Economic Review: Papers and Proceedings,Vol. 98 No. 2, pp. 339-44.

Reinhart, C.M. and Rogoff, K.S. (2008), “This time is different: a panoramic view of eightcenturies of financial crises”, NBER, working paper, No. 13761, NBER, Cambridge, MA.

Review of International Political Economy (1994), Vol. 1 No. 1, Spring.

Review of International Political Economy (1996), Vol. 3 No. 3, pp. 528-37.

Soddy, F. (1926), Wealth, Virtual Wealth and Debt, George Allen & Unwin, New York, NY.

Taleb, N. (2007), The Black Swan, Random House, New York, NY.

Veblen, T. (1923), Absentee Ownership and Business Enterprise in Recent Times. The Case ofAmerica, introduction by Robert Leckachman, Beacon Press, Boston, MA (reproduced1967).

About the authorsRoy E. Allen is Professor of Economics and Dean in the School of Economics and BusinessAdministration, Saint Mary’s College of California. His recent books are Human EcologyEconomics: A New Framework for Global Sustainability (as editor, Routledge, 2008) and FinancialCrises and Recession in the Global Economy (Edward Elgar, third edition forthcoming 2009). Hisresearch interests include globalization, sustainability studies, financial systems, and use of thehumanities to gain critical insights into the functioning of the economic system. Roy E. Allen isthe corresponding author and can be contacted at: [email protected].

Donald Snyder is Professor of Business Administration in the School of Economics andBusiness Administration, Saint Mary’s College of California. His most recent publication is“Strange priors: understanding globalization” (in Human Ecology Economics: A New Frameworkfor Global Sustainability, Routledge, 2008). His research interests include evolutionary andcomplex systems among other ways to model the economic system, economic growth anddevelopment, globalization, and financial market dynamics.


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The crisis: a return to politicaleconomy?

Loong WongSchool of Business and Government, University of Canberra,

Canberra, Australia

Abstract

Purpose – This paper aims to examine the current financial crisis, suggesting that most analyseshave attributed the crisis to a lack of business ethics, the rise of greed and lax regulation. Prescriptionsoffered to address this crisis draw accordingly on the need for greater regulation of market behaviour,business practices and boardroom pay. Whilst these reforms are necessary, they fail to recognise thatsuch business practices have their roots in an extreme political and economic ideology – neoliberalmarket fundamentalism. This paper seeks to suggests that a greater appreciation of the nexus betweenpolitics, philosophy and economics is critical in order to develop a different practice. As such, theauthor provides a socio-historical and political context for understanding the present crisis beforeoffering a critique and reform of the business educational agenda. The author argues that such acontext would engender greater understanding of business practices and systems for both studentsand practitioners and would go some way in enabling them to fashion a more critical reflexive andengaged practice.

Design/methodology/approach – The paper draws on a critical-historical review of the literatureon the crisis. In so doing, the paper opens up the analysis to philosophical and political approaches tounderstanding financial crises.

Findings – The paper finds that explanations for the crisis can be found through a criticalappreciation of philosophical and political texts. This finding also suggests that current business andmanagement education and practices can benefit from an incorporation of these historical strands ofthought.

Research limitations/implications – In drawing on various strands in philosophy, politics,economics and sociology, the paper finds that a singular account for the crisis is flawed. The paperalso finds that a richer and deeper appreciation of the crisis can be found through a critical-historicalpositioning of the crisis. This necessitates an understanding of politics and philosophy in businesspractices and education.

Practical implications – In explaining the crisis, the paper suggests that many of the currentfinancial “innovations” are problematic and a more critical approach is needed to engage with these“new” innovations.

Originality/value – The paper seeks to open up new vistas for business education and practices.Through a critical-historical interrogation of the crisis, the paper opens up new spaces forunderstanding international economics and business practices. This reflexivity is often missing ininternational business studies and most management practices.

Keywords Political economy, Recession, Politics, Capitalist systems, Education,United States of America


Introduction“Modern history’s greatest regulatory failure”; “The end of American capitalism as weknow it” – these are just two of the headlines thrown up by the credit crunch, bothappearing in the Financial Times (FT). In the course of a single week, we have seen thecollapse of three of America’s biggest financial institutions: on Sunday, 13 September



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2008, Bank of America announced it was buying out Merrill Lynch, one of the world’smost famous investment banks; on the following Monday, Lehman Brothers, the fourthlargest securities firm in the USA, filed for bankruptcy; and, on Tuesday, the USFederal Reserve invested $85 billion in a takeover of AIG, America’s largest insurancecompany. More recently, on Thursday, 25 September, the huge US bank WashingtonMutual, in a state of collapse, was taken over by JPMorgan Chase, in a move describedas “the biggest bank failure in American history” (Scholtes et al., 2008).

This panic on the world’s stock markets is a reflection of the underlying crisis ofworld capitalism, as it plunges into the deepest slump since the 1930s. Five Europeanbanks have collapsed in as many days. Despite the $US700bn bailout, the crisiscontinues unabated. The German government was forced to intervene to bail out thereal estate giant, Hypo, amid growing panic in the financial sector. BNP Paribas wasforced under Belgian government pressure to take over Fortis’s operations in Belgiumand Luxemburg. This followed the decision of The Netherlands government tonationalise Fortis in The Netherlands. Turmoil has also hit France, where Caissed’Epargne is likely to merge with Banque Populaire, and Italy, with Unicredit goingunder. In Iceland, the economic crisis has forced the government to nationalise one ofits biggest banks, Glitnir, while a large investment house collapsed; the authorities alsodrew up sweeping powers to nationalise banks and sack executives as the countryfaced bankruptcy. The krona fell as much as 45 per cent against the euro, as thecountry faced a balance of payments crisis. The crisis is producing panic everywhere.According to the FT:

Yesterday’s fresh outburst of panic on global markets was final proof that as financial crisesgo, we are now in the big league. Comparisons with the dotcom bubble or even the Asiancrisis of 1997 are inadequate. We must think of 1987 or 1929.

The article continues:

With hindsight, 1987 was more contained than today. The brief, savage fall in world equitiesseemed the prelude to a downturn in the real economy. But the real world sailed on, and otherasset classes were largely unscathed.

Compared to 1929, there are two main differences today. First, world policy makers havegrasped the scale of the threat more quickly and are prepared for much more drastic action.Against that, the financial system is more complex. And thanks to modern communications,the pace has accelerated. So any policy action is uncertain in its effect and generally out ofdate by the time it arrives (Financial Times, 7 October 2008).

In the last few months, companies that were thought to be too big to fail have all eitherfiled for bankruptcy, been “bailed out” by the government, or been nationalised. Mosteconomists do not know the depth and extent of the loss. As Dominique Strauss-Kahnwrites in the FT:

But with much of the losses yet to be realized, and with the financial crisis now acute, it hasbecome clear that nothing short of a systemic solution – comprehensive in tackling theimmediate fallout and comprehensive in addressing the root causes – will permit the broadereconomy, in the US and globally, to function with any semblance of normality (FinancialTimes, 22 September 2008).

Indeed, the US economy no longer functions with any “semblance of normality”. AsDavid Wessel (2008) noted in the Wall Street Journal, “The past 10 days will be

A return topolitical

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remembered as the time the U.S. government discarded a half-century of rules to saveAmerican financial capitalism from collapse”. For years the USA economy appeared tobe defying the laws of economic gravity, going up and up. However, its present fall ismore spectacular and is far from over. The crisis has clearly spread from the financialsector to the rest of the economy. The difference with 1929 is that the world is far moreinterdependent and the scale of the crisis is potentially far bigger. All the factors thatdeveloped the boom over the past 20 years are now turning into their opposites. Theprofits bonanza has crashed. The market is contracting rapidly. Consumer spending isfalling. The FT opined: “We are now, unquestionably, in the worst financial crisis since1929. We do not know how many more banks and institutions will fail – WashingtonMutual, the US counterpart of HBOS, is under severe pressure – but Bear Stearns,Fannie Mae and Freddie Mac, Lehman and AIG are plenty” (Financial Times, 19September 2008).

Financial turbulence originating in the USA has slowly expanded and worsened.There is now “the messy reality of global financial crisis” (Rubin, 2003, p. 297). Banksand financial institutions are weighed down by huge losses caused by “non-performingloans”. Lending channels are choked up, as lenders are being called to pay back theirloans, to clean up their balance sheets, and fearful that they are “throwing good moneyafter bad” and will not be paid back. There is real danger of a breakdown of thefinancial system. The new president of the International Monetary Fund has statedthat the current turmoil poses the greatest financial crisis since the 1930s (Weisman,2008).

Fortune magazine, in its April 14 issue, analyses the stakes this way:

The fear – a justifiable one – is that if one big financial firm fails, it will lead to cascadingfailures throughout the world. Big firms are so interlinked with one another and with othermarket players that the failure of one large counterparty, as they’re called, can drag downcounterparties all over the globe. And if the counterparties fail, it could down thecounterparties’ counterparties, and so on (Sloan, 2008).

In this paper, I seek to position current academic reflexive comments on the presentglobal crisis. Some have commented on the inadequacy of management and businesseducation, particularly its neglect of social and political questions (Corbyn, 2008).Others, including the popular press, have drawn our attention to the “continuing”relevance of Marx and even Alan Greenspan in Washington recently saw the crisis as abattle between capitalism and socialism. I therefore turn to a recent piece in theFinancial Times which seeks to contextualise and position Marx within ourunderstanding of the present crisis. I next examine critically the work of Marx andshow how it enables us to frame the present crisis before examining the current phaseof neoliberal capitalism and the rise of finance capital. Free market economist MartinWolf sees the crisis as one arising from the mutation of capitalism from “mid-20thcentury managerial capitalism into global financial capitalism” (Wolf, 2007).Contemporary Marxist John Bellamy Foster also recognised this qualitative shift,but saw it as “a new hybrid phase of the monopoly stage of capitalism that might betermed ‘monopoly-finance capital’” (Foster, 2007, p. 1). The paper next discusses theresponses to the crisis and argues that unless fundamental reforms are introduced,including an injection of politics within business education and our practices, the crisiswill recur again in the future.

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The MBA, the crisis and Marx

Not many MBA courses include the reading of Marx’s Capital. Not many CEOs could quotefrom The Communist Manifesto. But there are times when it pays even the most passionatebelievers in capitalism (and I count myself among them) to heed the bearded Cassandra.Times like these: the worst bear market since the Great Depression – although Marx himselfwould have preferred to call it a “crisis of capitalism”.

So wrote Niall Ferguson, Professor of Political and Financial History at Oxford andVisiting Professor at the Stern School of Business, New York University. In his article,“Full Marx” (Ferguson, 2008), Ferguson noted that “Marx’s insights into capitalism canstill illuminate [. . .] Marx got one thing right. Behind the bubbles and busts of thecapitalist system there is a class struggle; and that class struggle is the key to modernpolitics”. He went on: “This may read like heresy, especially in the pages of theFinancial Times”, said Ferguson, somewhat on the defensive. “But a little reflection onthe current crisis of capitalism will show otherwise. Not that today’s class strugglebears much relation to that of Marx’s day”. In fact, says Ferguson, there is “a conflictwithin the bourgeoisie” where “the history of capitalism is the history of expropriationand the concentration of wealth – the means of production – in the hands of anever-decreasing minority [. . .] widening inequality and globalisation”, makingcapitalism crisis-prone.

Ferguson also pointed out “the real point is that many of the defects [Marx]identified in ninteenth century capitalism are again evident today. In the last 20 years,there has been a significant increase in inequality in the pre-eminent capitalisteconomy, the United States. In 1981, the top 1 percent of households owned a quarter ofAmerican wealth; by the late 1990s, that single percentage owned more than 38percent, higher than at any time since the 1920s”. Commenting on the present crisis, henoted that “The global implications of a slowdown in the vast American economy arealarming. The other key element of the late-90s bubble was the willingness of foreigninvestors to pour money into the US, funding an enormous balance of payments deficit.These foreign investors are now staring at income statements spattered with red ink.And they have more to worry about than American investors, because a slide in thedollar exchange rate threatens to make those losses even bigger. If the experience of the1980s is anything to go by, the dollar could fall steeply as foreign investors sell off. Theresulting reduction of American imports would further hurt the rest of the world”. Hewent on to advise us that we should not “prepare for the death-knell of capitalism justyet” and that there was good news: the US stock market has simply retraced its stepsback to mid-1997, the USA is free from the spectre of inflation, the American financialsector is in far better health than its Japanese counterpart, and above all, the Fed is notthe Bank of Japan. For him, we should relax: “the recession was last year, and youbarely felt it. This is the kind of crisis of capitalism Argentineans can only dreamabout”. For him, there are lessons to be learnt and “It is the social structure of Americancapitalism that is in real need of attention”. In Ferguson’s analysis, the primary culpritis the rise of the new class of CEOs and the lack of supervision of their activities[1].

Clearly there is an element of truth in his claims but so are other explanations, forexample the lack of regulation and the lack of transparency was glaring as risks wereundetermined (Walker, 2008). Others have castigated the US economy for its“monstrous bubble of cheap credit [. . .] with one bubble begetting another” – in thewords of Stephen Roach, chairman of Morgan Stanley Asia. Elsewhere Roach has


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observed that “America’s bubbles have gotten bigger, as have the segments of the realeconomy they have infected”. Household debt has risen to 133 percent of disposablepersonal income, while the debt of financial corporations has hit the stratosphere, andgovernment and non-financial corporate debt have been steadily increasing (Roach,2007). This huge explosion in debt – consumer, corporate, and government – relativeto the underlying economy (equal to well over 300 percent of GDP by the housingbubble’s peak in 2005) has lifted the economy, created an appreciation of assets andwealth, and leads to growing instability. This was brought about as investors began torealise that a large proportion of the debt securities that they were trading were basedon sub-prime mortgages that were never going to be paid back. The banks hadsupposedly discovered how to limit their own exposure, while raking in the charges, byrepackaging poor debts as CDOs (collateralised debt obligations) and selling them onto their clients, in ways that supposedly spread and insured the risk. Morefundamentally, a second, huge financial system based on banks borrowing from otherbanks to buy equities (the general term for assets traded on financial markets) on thebasis that the value of these equities would continue to rise indefinitely, developedoutside the normal banking network (Shiller, 2008). It was unregulated, not transparentand way too leveraged. If these equities begin to fall in price, the huge debts of thesebanks become exposed, and the contradictions in the system become apparent[2].

The spectre of MarxIn their article “Production and finance”, Magdoff and Sweezy (1983) argued that thatthe normal path of the mature capitalist economies, such as those of the USA, the majorWestern European countries, and Japan, is one of stagnation rather than rapid growth.In this perspective, today’s periodic crises, rather than merely constituting temporaryinterruptions in a process of accelerated advance, point to serious and growinglong-term constraints on capital accumulation. They saw financial explosion as aresponse to the stagnation of the underlying economy, helping to “offset the surplusproductive capacity of modern industry”. A capitalist economy in order to continue togrow must constantly find new sources of demand for the growing surplus that itgenerates. That’s why, for example, money jumps into Thai real estate markets oneday, and pulls out and goes into ethanol production in Brazil the next . . . and then backto mortgage securities. And there is something else: the inflows and outflows ofshort-term and speculative capital also act as a perverse means of imposing disciplineon and restructuring capitals – a major manufacturing firm can be starved of credit orthreatened with a leveraged buyout. And this kind of “financial discipline” has beenimposed on whole countries in the Third World (Rude, 2004). All this is part of thereason that financial instability is a constant feature of capitalism in its moreglobalised and financialised forms of existence. There comes a time, however, in thehistorical evolution of the economy when much of the investment-seeking surplusgenerated by the enormous and growing productivity of the system is unable to findsufficient new profitable investment outlets[3].

In recent months, the spectre of Marx has been revived. Marxists claimed that thesecontradictions were anticipated by Marx. Whilst Marx was never able to complete atheory of crisis in his lifetime (volumes II and III of Capital remained unfinished whenhe died), Marxists traditionally link capitalist crisis to the tendency of the rate of profit

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(surplus value extracted per unit capital invested) to fall over time. In order to deducethis tendency, Marx divides this “unit capital invested” into two parts:

(1) constant capital, which invested in the production process (e.g. the plant, rawmaterials etc.); and

(2) variable capital, which is invested in staff wages.

Surplus value can only be extracted from workers, not machines. Surplus value is thevalue of the labour given by a worker above and beyond that which is paid to him orher as wages; hence it is the source of profit for the capitalist. Therefore, increasing theconstant capital, for example, by investing in new machinery, whilst doubtlessimproving the production process, will mean that for the same surplus value extracted,a greater total capital (constant and variable) will have been invested; hence, the rate ofprofit will fall. This manifests itself as a fall in prices of commodities (think about howthe price of electronic goods falls over time).

Of course, this tendency is not a law – there are other interacting factors which cancause the rate of profit to rise. Marx identified more intense exploitation of labour,reduction of wages below their value, cheapening of the elements of constant capital,and the increase in share capital, amongst other factors. Clearly, the tendency for therate of profit to fall represents a huge contradiction in the capitalist system:competition forces capitalists to increase constant capital (by investing in newtechnology, for instance), which leads to an ever-diminishing rate of return on thatinvestment.

However, this current crisis originated in the financial sector, which in this currentepoch dominates world capitalism. According to Marx, capital agglomerates and seeksgreater returns and a higher rate of profit. This growing concentration for Marx leadsin turn, at a certain point, to a new fall in the rate of profit. Accordingly, smaller,fragmented pools of capitals are thereby forced onto new “adventurous paths” –speculation, credit swindles, share swindles, crises (Marx, 1909, Volume III, pp. 469ff).Marx is clearly identifying how concentration (i.e. the grouping of more and morecapital under the control of fewer and fewer capitalists, tending to monopoly) is adriving force behind falling rate of profit, and how this falling rate of profit drivescapitalists to seek profit through speculation, in effect making “free money” throughtrading bits of paper. This increase in share capital, claims Marxists, can counteractthe tendency of falling rate of profit. In the age of huge monopoly capitalism, where 500companies control 45 percent of the world’s economy, it is hardly surprising that it isincreasingly hard to turn a large profit without engaging in “risky” financial activities(i.e. without gambling other people’s money) – credit, shares, derivatives and otherassets. In this carnival of money-making, the banks lent vast sums of money andvastly over extended their loans, especially in the property market[4]. But boom turnedinevitably to bust, threatening to bring down all in its wake.

The present crisis is not one arising from a lack of money; on the contrary, it is thecrisis that causes a lack of money. When the economy enters into crisis, credit dries upand people demand hard cash instead. This is the effect of the crisis, but in turn itbecomes cause, pushing down demand and creating a downward spiral. Bankers andgovernments insist that the cause of the crisis is the fact that the financial system hastoo little capital. Clearly if we look at the last two decades, banks have been and arecontinuing to make huge profits. For example, in Australia both the St George Bank


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and Westpac bank reported annual record profits in late October 2008. It would surelybe incredulous for banks to claim they do not have enough capital. Actually, there wasa huge amount of loan capital in circulation during the boom, and this superabundanceof capital itself found itself flowing into speculation, especially in the housing sector.This was the basis upon which the subprime mortgage scandal arose and flourished,generating unimaginable amounts of fictitious capital. But as long as vast profits werebeing made and investors were happy, nobody cared. Let us take just one example: thecredit default swap industry. This market allows two parties to bet on the likelihood ofa company defaulting on its debt. It has grown to about $90 trillion in notional amountsinsured – that is to say, probably more than double the total outstanding credit in theworld. But contracts are registered nowhere but in the books of the partners. Nobodyknows the real volume of trading, which therefore exposes the world economy to ahuge risk. That explains the panic on Wall Street and in the White House[5]. They fear– correctly – that any severe shock can bring the whole unstable edifice ofinternational finance crashing down, with unforeseen consequences. Unless and untilall the bad assets are removed, many institutions will still lack sufficient capital toextend fresh credit to the economy. Marx described this stage in the economic cyclelong ago:

That means of payment are scarce during the period of crisis goes without saying. Theconvertibility of bills of exchange has substituted itself for the metamorphosis ofcommodities themselves, and so much more so at such times, as a portion of the firmsoperates on pure credit. An ignorant and mistaken bank legislation, such as that of 1844-45,can intensify this money crisis. But no manner of bank legislation can abolish a crisis [. . .] In asystem of production, in which the entire connection of the reproduction process rests uponcredit, a crisis must obviously occur through a tremendous rush for means of payment, whencredit suddenly ceases and nothing but cash payment goes. At first glance, therefore, thewhole crisis seems to be merely a credit and money crisis. And in fact it is but a question ofthe convertibility of bills of exchange into money. But the majority of these bills representactual sales and purchases, and it is the extension of these far beyond the needs of societywhich is at the bottom of the whole crisis. At the same time, an enormous quantity of thesebills of exchange represents mere swindles, and this becomes apparent now, when they burst.There are furthermore unlucky speculations made with the money of other people. Finally,they are commodity-capitals, which have become depreciated or unsalable or returns that cannever more be realized. This entire artificial system of forced expansion of the reproductionprocess cannot, of course, be remedied by having some bank, like the Bank of England, giveto the swindlers the needed capital in the shape of paper notes and buy up all the depreciatedcommodities at their old nominal values. Moreover, everything here appears turned upsidedown here, since no real prices and their real basis appear in this paper world, but onlybullion, metal coin, notes, bills of exchange, securities’ (Marx, 1909, Volume III, Chapter 30,pp. 575-6, my emphasis).

Marx further explained that capitalist production depends, among other things, oncredit, and that “the solvency of one link in the chain depends upon the solvency ofanother”. The chain can be broken at numerous points. And that sooner or later, creditmust be paid off in cash. This fact, for Marxists, is all too frequently forgotten by thosewho become indebted during the process of capitalist upswing. In the first phase ofcapitalist expansion, credit typically acts as a spur to production: “the development ofthe productive process extends the credit, and credit leads to an extension of industrialand commercial operations” (Marx, 1909, vol. 3, pp. 563-5). This has a tendency to push

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the market beyond its normal limits, almost limitless[6] but as soon as a crisis appears,the illusion is shattered and financial returns and prices all become problematic toenforce.

Marx’s views are not so different from the recent work of Thomas Palley (2007). Inhis paper, “Financialization: what it is and why it matters”, Palley notes that “the era offinancialization has been associated with generally tepid economic growth. [. . .] In allcountries except the U.K., average annual growth fell during the era of financializationthat set in after 1979. Additionally, growth also appears to show a slowing trend sothat growth in the 1980s was higher than in the 1990s, which in turn was higher than inthe 2000s”. He goes on to observe that “the business cycle generated by financializationmay be unstable and end in prolonged stagnation”. Nevertheless, the main thrust ofPalley’s argument is that this “prolonged stagnation” is an outgrowth offinancialization rather than the other way around. Thus he contends that suchfactors as the “wage stagnation and increased income inequality” are “significantlydue to changes wrought by financial sector interests”. The “new business cycle”dominated by “the cult of debt finance” is said to lead to more volatility arising fromfinancial bubbles. Thus “financialization may render the economy prone todebt-deflation and prolonged recession”. Palley calls this argument the“financialization thesis”[7].

Neoliberalism and financialisationFor the past quarter of a century, neoliberalism, sometimes called marketfundamentalism, the policy of non-intervention in the economy, has been theideology, and the set of policies that go with it. Now the economic crisis is forcing theauthorities to intervene, regulate, and even nationalise firms. Is neoliberalism dead?

Martin Wolf, economic guru of the Financial Times, suggests the neoliberalrulebook needs to be torn up. He dates the change from the collapse of Bear Stearns lastMarch. “Remember Friday March 14th: it was the day the dream of global free-marketcapitalism died. For three decades we have moved towards market-driven financialsystems. By its decision to rescue Bear Stearns the Federal Reserve, the institutionresponsible for monetary policy in the US, chief protagonist of free market capitalism,declared this era over. It showed in deeds its agreement with the remark by JosephAckerman, chief executive of Deutsche Bank that, ‘I no longer believe in the market’sself-healing power.’ Deregulation has reached its limits”.

As the crisis bit into the popular consciousness, the popular press recorded the samethought. The Daily Express (DE) headline screamed, “Don’t let the spivs destroyBritain” (Daily Express, 17 September 2008). The article began, “Millions of Britishfamilies are facing the destruction of their livelihoods as the nation’s economy teeterson the brink of catastrophe, brought low by the greed and stupidity of spivs in highfinance”. Here, greed and Gordon Gekko is the cause but clearly not compelling orpersuasive enough. Many of these policies have their roots in the 1970s and theemergence of a new neoliberal ideology. In 1973-1974 we saw the first generalised crisisof world capitalism. The preceding period from 1948 to 1973 was seen to be a goldenage for world capitalism. Production went up year after year, as did living standards.In this situation of full employment, everyone was seen to be benefiting and theperception was that capitalism had changed fundamentally. Booms and slumps, it wasgenerally believed, had been banished to the history books. Clearly the 1973-1974


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recession came as an enormous political shock. The working class internationallymobilised to defend the gains of the post-war period. The ruling class, for their part,was determined to drive down living standards and restore the rate of profit. As aresult of this clash, a revolutionary wave swept across the capitalist world. All theearlier certainties were thrown up in the air and called into question. In addition torapidly rising unemployment the world economy experienced spiralling prices. Theimmediate trigger for inflation was the oil price crises of 1973 and 1979. Never beforehad we experienced inflation together with recession. This was called stagflation andin its wake neoliberalism was spawned.

Associated with neoliberalism was “globalisation”. Tariff barriers were comingdown all over the globe. Capital was expanding everywhere and everything was“deregulated”[8]. Its proponents argued that “globalisation” meant that resistance wasfutile. Because capital was endlessly mobile, nation states were becoming powerless.They had to reduce taxes on profits and obey the multinationals’ every wish or theywould simply move their money elsewhere. Workers would be “blackmailed” intoaccepting lower and lower wages or they would lose their jobs altogether. It was a raceto the bottom[9]. Neoliberal triumphalism received a further fillip as the Soviet Unioncollapsed and capitalism, it was claimed, had won the Cold War! So it seemed there wasno alternative to capitalism (or “the market”, as apologists came to call it) and itsproponents proclaimed “the end of history” (Fukuyama).

Movement of money used to be analysed in terms of trade. For example, in buying akilogram of potatoes, goods go one way and money the other. Now that’s all old hat.The movements of foreign exchange are now no longer the handmaiden of trade. By1990, banks were creating “structured investment vehicles” and other derivative assetsto bypass the reserve requirements of the Basel Bank regulations. The assumption wasthat geographical and sector dispersion of the loan portfolio and the “slicing anddicing” of risk would convert all but the very lowest of the tranches of these investmentvehicles into safe bets. It also led to the blurring of the lines between commercial andinvestment banking, insurance and real estate in the FIRE (finance, insurance and realestate) sector. This led to financial innovative packages enabling high leveraging offunds accessible through low interest loans[10]. As a Financial Times report put it atthe close of 2007:

While investors are scrutinizing some of the industry’s best-known names, a spectre will besilently haunting events: the state of the little known, so-called “shadow” banking system. Aplethora of opaque institutions and vehicles have sprung up in American and Europeanmarkets this decade, and they have come to play an important role in providing credit acrossthe system (Tett and Davies, 2007).

This “hidden” system had expanded rapidly in the 1990s and 2000s as a consequenceof deregulation, which allowed many financial institutions to take on bankingfunctions and loosened the rules that govern borrowing and lending. Effectively, therewas an explosion in money supply and there was a greater competition to purchasethese assets. For every dollar that crosses the exchanges for trade, sixty go for purespeculation. Speculative capital movements, swaps, forwards and options nowoverwhelm trade in their importance for the balance of payments (Augar, 2006)[11]. Asa percentage of total US corporate profits, financial sector profits rose from 14 percentin 1981 to 39 percent in 2001 (Brenner, 2002, p. 76; see also Glyn, 2006). Financialglobalisation has simply become detached from the real world of surplus value

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production. For globalisers, the explosion of global financial flows shows capitalismhas at last created one world.

More importantly, it increased their powers and spheres of operations: from theirtraditional underwriting and brokerage, from mergers and acquisitions (M&As) andinitial public offerings (IPOs), from proprietary trading and risk arbitrage; and frompositioning themselves and their clients in relationship to the wider impact of a mergeror some other major event, enabling them to gain from changes in relative priceswhether or not a deal goes ahead. In lifting themselves from space (territory), corporateactivities now also seek to supersede the temporal dimensions; for example, vast fundscan now be shifted in nano-seconds and central banks have little control over theirexchange rate, which is mainly driven by the market.

Globalisers argue that “market forces” are now sweeping all before them. Now, theglobalisers say, the state has to give in, privatise, deregulate and comply with the“demands” of the market. These globalisers, however, fail to understand that the stateis itself an economic actor, a power affecting economic behaviour. As Bukharin pointsout, “The fact is that the very foundation of modern states as definite political entitieswas caused by economic needs and requirements. The state grew on the economicfoundation; it was an expression of economic connections; state ties appeared only asan expression of economic ties” (Bukharin, 1929, p. 63). He goes on: “The stronger statesecures for its industries the most advantageous trade treaties, and establishes hightariffs that are disadvantageous for the competitors. It helps its finance capital tomonopolise the sales markets, the markets for raw materials and particularly thespheres for capital investment” (Bukharin, 1929, p. 137). This state of play – theinteraction between economic power and state power – is still a central feature ofmodern economic rivalry, but in the light of the crisis, all has changed. Governmentsnow intervene to stop the markets from collapsing and indeed, bailouts have been theorder of the day. As Sutherland observes: “In the US, hundreds of billions of dollars ofbanking risk will be transferred to the federal government, adding to America’s hugeburden of debt and increasing its reliance on foreign investors [. . .] Policymakers nowface formidable challenges: fighting the fire, then repairing the financial system whilekeeping a lid on inflation, then putting in place effective new regulation”. For her, theworst is yet to come. She goes on, “This crisis should prompt us to reappraise ourrelationship with money and debt, and to think hard about how we can create a fairerand more inclusive version of capitalism. There should be no return to the market’sfalse gods”.

Indeed, there are deeper questions that lie beyond the wrangling over the bail-out.The events that have been unfolding over the last six months have made it abundantlyclear that voluntary regulation does not work. This has been echoed by Europeanleaders, including President Sarkozy Agreeing with this sea change in consciousness.“[The] idea of an all powerful market without any rules and any political intervention ismad”. So the unchallenged economic orthodoxy of yesterday is now mad! He goes on,“Self regulation is finished. Laissez faire is finished. The all-powerful market which isalways right is finished’. Vladimir Putin, Russia’s Prime Minister, sees this as anAmerican problem exported out. He proclaimed:

Everything happening now in the economic and financial sphere began in the United States.This is not the irresponsibility of specific individuals but the irresponsibility of the systemthat claims leadership.


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Others similarly agreed: “The origin and centre of gravity of the problem is clearly inthe USA”, German finance minister Peer Steinbruck pronounced. And Gordon Brown,prime minister of UK, said his nation’s economic problems were imported fromAmerica, a view shared by opposition leader David Cameron (Stelzer, 2008).

This is all trenchant criticism – unprecedented for a generation. Their outrage isdirected at financial “geniuses” they now realise were simple charlatans, who havebeen helping themselves to the good things in life at our expense and landing us all inthe mire in the process. Their call is for regulation. Capitalism, we are told, would be agood system if only it were adequately regulated. In ‘A shattering moment inAmerica’s fall from power’, John Gray (2008) argues that “It is America’s political classthat, by embracing the dangerously simplistic ideology of deregulation, hasresponsibility for the present mess”. In the same issue of The Observer, RichardWachman writes under the headline, “This transforms the financial system. Forever”.He sums up his argument: “US power is ebbing away and free market fundamentalismis an outdated ideology”.

Forever is a long time in politics. It is true that the USA is running a huge deficitwith the countries it trades with. This is surely a sign of economic weakness. Thecountry is up to its ears in debt to the rest of the world. The dollar is derided. UShegemony is weakening. Is it still the one, unassailable economic superpower? The realquestions remain:

(1) What is the real relation between capitalism and regulation?

(2) What other country can lead the capitalist world and impose the norms andprinciples without which it cannot function?

Capitalism will always go through cycles of boom and slump. But the 1929 Wall StreetCrash led directly to the Great Depression, the worst capitalist slump so far. EconomistCharles Kindleberger sought to answer the question why the Great Depression was sodeep and so widespread in his book The World in Depression 1929-39. His explanationwas that the slump was so severe and long-lasting because there was no internationallender of last resort. We do not believe this offers a complete explanation for thedisastrous decade, but it is an important aspect of the truth. Before the First WorldWar Britain was regarded as the hegemon and acted as the lender of last resort. Thegold standard was really the sterling standard. The war showed that British hegemonywas under decisive challenge.

After the Second World War the USA asserted its supremacy under the BrettonWoods Agreement, which determined the terms of world trade. It imposed the dollar asde facto world currency. And it had the power to act as international lender of lastresort. Between the wars the USA was the most powerful capitalist nation, but it didnot impose its power upon the world economy, remaining isolationist. Thisinternational anarchy led to “beggar-my-neighbour” devaluations and the virtualdrying up of world trade. This impacted in turn on the economies of every nation onthe globe. Now US hegemony is under challenge, but no clear alternative is in sight. IfKindleberger’s analysis of the 1930s is right, and we are entering a similar era today,then we are in for stormy times.

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Reforms and the big pictureIt has been argued that the present crisis is the result of regulatory failure to guardagainst excessive risk-taking in the financial system, especially in the USA (Gray,2008; Walker, 2008). It is further argued that “we must ensure it does not happenagain”. At its core are a number of fundamental questions: the issue of businesspractices (which includes the practices of management, greed, business ethics andmanagement education) and that of regulation, particularly the role of the state ineffecting such regulations. The latter is particularly telling and ironic given that mosteconomists and commentators have argued precisely the opposite: that all regulationswere bad for business and should be abolished (this was particularly advocated for thefinancial sector). The market, its proponents claim, would deliver the right and mostefficient outcome and wealth was unbounded. Similarly, present calls to ban(temporarily) the practice of “selling short” are unrealistic. In order that the marketscan function, it is necessary for people to buy and sell shares, and they must do so onthe basis of estimating whether the share price is going to rise or fall. The idea that it ispermissible to buy shares only when they are rising is clearly an absurdity.

Clearly, the present crisis presents an abertura for change. As such, some have seenin the wake of the present crisis attempts to redress the capital-society-labourrelationship. Regulating the share market, curbing excessive bonuses and regulatingboardroom pay, minimising risks for speculative activities and ensuring security forthese transactions have all been touted as necessary reforms to make capitalism work,but such “regulation” is still driven by profits and does not necessarily make theeconomy more stable or provide greater equality, but rather provides conditions forgreater speculation as speculators can now depend on government bailouts or theirdecisions. Whilst laws and regulations can be enacted, reining in greed and regulatingboardroom pay is patently not feasible; how and by what mechanisms are thesepractices to be performed? Similarly, the (re)regulation of the finance sector andgovernmental interventions in the sector do not constitute a radical change[12]. In thepast, states’ entities were highly involved in financial transactions and they was highlyregulated. What has transpired is the reemergence of the state in managing fiscal crisesengendered by finance-state actions which precipitated the crisis in the first instance,the “deregulation” of the economy and the “retreat of the state”. In effect, the state hasbeen brought back in to enforce fiscal discipline. This requires the state to protect theinterest of vested interests by giving them vast subsidies, paid for out from staterevenues[13]. Speculators and bankers are rewarded for their nefarious activities by thestate, which buys up all their losses, then spends further vast amounts of thetaxpayers’ money to make them profitable, and when discipline has been restored, tosell them back to the bankers, who will then reap the rewards from such stabilisation(Augar, 2008).

The recent events are a graphic reminder of the anarchic nature of capitalism. Theidea that this can be controlled by governments and central bankers is nonsense. Onthe contrary, the uncontrollable nature of capitalism has never been more apparentthan at the present time. Moreover, the unprecedented intensification of theconcentration of capital, where vast amounts of capital (much of it fictitious) are movedabout the world at the caprice of a small number of people, lends the whole process aneven more convulsive and unpredictable character. The present nervousness on worldstock markets is thus the first of what will be a series of tremors which, for anyone with


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eyes to read, announce the beginning of the end of the present cycle. What we arewitnessing now is that a particular dynamic of growth, marked by intensifiedfinancialisation, is generating new contradictions and new barriers to sustainedaccumulation.

Here we come to a basic point of this analysis: a financial crisis has broken outbecause of the severe imbalances built up between the financial system – and itsexpectations of future profits – and the accumulation of capital; that is, the structuresand actual production of profit based on exploitation of wage-labour. The state isintervening to head off further damage and to discipline and restructure the financialsystem. But the very complexity of the “financial packages” created during thespeculative boom – with their bundled-up loans and long strings of finance – areproducing new challenges for policy-makers. As one Yale economist put it, perhapsunintentionally echoing a phrase from Marx: “like the sorcerer’s apprentice, we havecreated things we do not understand and cannot easily control” (Dapice, 2008).

This explosive uncertainty is developing against a larger international canvas.Major shifts are taking place in the world capitalist economy. The European marketrecently eclipsed the US market in size. China’s growing demand for raw materials tofuel its export economy is making it a new player in the scramble for resources andcontrol over them. And China’s increasing importance as a supplier of capital to theUSA is giving it new leverage. Russia is reemerging as a world imperialist player,owing in part to its vast energy reserves and rising oil and gas prices. At the same time,and at this very moment of financial crisis, the USA’s freedom of manoeuvre isseverely hobbled – and this includes its ability to stimulate the economy through fiscaland monetary policy. The USA has never run such large current account deficits andno single country’s deficit has ever bulked as large relative to the global economy. Thepresent crisis clearly foreshadows changes in geo-economic and geopolitical realitiesand may signal the passing of a great power and the emergence of a “new” power. Itwill also, in the short term, usher in a new regime of global governance and(re)regulation of financial markets. Maybe, business schools and international businesspractitioners can also revisit basic principles of economics and explore therelationships between economics, philosophy and politics again.

Lessons learnedAs I have indicated, the present crisis provides us with an opportunity to reflectcritically on business practices, including management education. As academics, someof us have been guilty of presenting simple, linear solutions to our students. Weprivilege quantifiable measures and success is determined by these measurableperformance indicators. This is abundantly clear in courses in finance, strategicmanagement and finance, particularly in MBA and executive education. Most MBAprograms rely on American textbooks and case study materials, and they continue toconstitute the international benchmark which typically reproduces this “American”standard and ethos (Liang and Wang, 2004). Of late, the quality of MBA programs hasbeen and remains a subject of continual debate (Bennis and O’Toole, 2005; Cudd et al.,1995; Hettenhouse, 1998; Mitroff and Churchman, 1992; Porter and McKibbin, 1988;Roome, 2005). Henry Mintzberg (2004), for example, has been fairly critical and hascondemned MBA programs as promoting formulaic, generic, “cookie-cutter” responsesto business management issues and practices, rather than training people involved to

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manage (Pfeffer and Fong, 2002, 2004). For Mintzberg and his colleagues, educationmakes the issue of management worse if it merely involves a reproduction of theinsubstantial knowledge and skills offered (Gosling and Mintzberg, 2006; Mintzbergand Gosling, 2002). Ghoshal (2005) similarly opines:

Business schools do not need to do a great deal more to help prevent future Enrons [. . .] Theydo not need to create new courses [. . .] Our theories and ideas have done much to strengthenthe management practices that we are all now so loudly condemning (Ghoshal, 2005, p. 75; seealso Pfeffer and Fong, 2002, 2004). In focusing on being scientific, developing models andtechniques rather than the development of diagnostic capabilities, the MBA has become tooinstrumental and renders analysis simplistic. In the process, the MBA produces “critters withlopsided brains, icy hearts and shrunken souls” (Pfeffer and Fong, 2002, p. 80).

This concentration on models, financial indicators and performance and the lack ofreflexivity within the MBA means that many managers simply do not develop or havethe necessary skills to manage and/or be creative in their work and thinking (Weick,2003). Some academics (e.g. Daniel Pink, 2004) have argued that the MFA (the Masterof Fine Arts) may in fact be of more value than the MBA, because they promotecreative, innovative, “out-of-the-box” thinking and conceptualisation of problems.Business leaders have similarly echoed such sentiments, noting the dearth of criticaland creative thinking (Andrews and Tyson, 2004; Doria et al., 2003). Despite thesecriticisms, “MBA fever” has shown little signs of abating.

Indeed, executive education, MBA and business education in general have all beencriticized for its simplicity, positivity and linearity. Financial measures have all beenoverly privileged and short-term performances are lauded and celebrated throughrecord financial profits. Business strategies and plans typically rely on a planning ordesign scenario but as the crisis shows, such approaches are inadequate; they do notprovide us with real-time information nor are they are complete. They also certainly donot take into account the dynamism inherent in market practices, and cannot factor infor example some behavioural practices, the run on credit, confidence quantum andherd behaviour. Equally problematic is the reliance on market solutions to “regulate”the economy. Indeed, many aspects of our “efficient” capitalism combined to producethe credit meltdown that now threatens ever more aspects of the global economy.

First and foremost was the private rating companies’ failure to accurately assessand honestly reveal the risks of securities based on a “bundle” of loans (securities thatprovide their owners with a portion of that bundle’s principal and/or interest). Thiswas especially true for securities based on mortgage loans issued in the years of thehousing boom. Investors around the world bought those securities based on thosecompanies’ ratings. Their purchases financed the US housing bubble. We know nowthat those ratings were badly mistaken. Owners of those securities around the globeare taking staggering losses and reducing their lending to all borrowers. Anxiety aboutthe risks of all sorts of borrowing has risen alongside deepening distrust of all riskassessments. Understanding why the rating companies contributed to this disasteropens a crucial window into today’s global credit crisis. It also teaches basic lessonsabout today’s globalised capitalism.

Since the crisis, it has become abundantly clear that global financial structures andsystems are arcane and inadequate. Its structures are unsophisticated andmanagement incompetent. The presumed sophistication of bank risk-assessmentmodels were no better than fig leaves; financial analysts use the tools of financial


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engineering for valuing options and constructing derivatives. To begin with, thesetechniques were used mainly to reduce uncertainty and hedge currency risk, to shape atrade limiting their exposure to the level in which the trader has confidence.Derivatives, such as swaps, options and other financial instruments, are used as toolslimiting such exposure (Buenza and Stark, 2004; Tett, 2007). Again, this practice pointsto the effects of one-dimensional reliance on economic and financial modellingtechniques, that is, as useful as they are, they are limited and cannot possibly accountfor the range of human responses and dynamism within complex business socialenvironments. In part, this is because the prospects of a given stock cannot be distilledin a single figure since the balance sheet of an enterprise will always comprise acomplex of receipts and liabilities in which the past, present and future uneasilycoexist. This is highly complex, interactive and reiterative; the deregulation of financialmarkets also further increased this “complexity” (Ingham, 2004). Moreover, withfinancial data, there is often a problem of a sample size that is not large enough tocapture their variance over a significant time period. In a long-term perspective theinformation available to someone basing themselves on today’s financial data is verylimited; by excluding the future, it is impossible to estimate and determine thefuture[14].

Second, we need to grasp the structure of the financial industry and the concomitantindustry that sells assessments of the risks attached to securities (including thosebased on loans). Even the most powerful corporations need the financial world toassess their own progress, to plan for the future and to generate growth.Financialisation, as such, encourages corporations to privilege financial functions,see themselves as accidental repositories of assets which, as circumstances change,must be continually broken up and reconfigured. Their credit-worthiness is determinedby banks and ratings agencies, especially if they wish to reassure investors and ensurecheap access to capital (Sinclair, 2005).

Of the 150 rating enterprises around the world, three dominate – Moody’s, Standardand Poor’s and Fitch. Barron’s Magazine (Laing, 2007) reported on a Morgan Stanleyresearch report which studied the 6,431 subprime residential mortgage-backedsecurities issued in 2006. Of these, 2,087 issues were rated AAA (the highest rating, thelowest risk); 1,266 were rated AA; and the rest were rated A or lower. Within one yearof being issued, most of these securities were re-examined by the rating companies andover 50 per cent were downgraded, i.e. given a new, lower rating[15]. Clearly there wasa problem with the ratings and the methodologies employed and whilst they could notbe held solely for the crisis, they “were key enablers, by countenancing andlegitimizing lethal capital structures”. As Brian Clarkson, the president of Moody’s,notes ruefully to Barron’s: “We misjudged the magnitude of the problem, the fact thatwhat we expected to be a tropical disturbance ended up being a Category 5 hurricane”.As risk evaluation equations unravelled, so did financial markets’ ability to judge theworth of financial institutions’ balance sheets.

Clearly, therein lies in the problem of reliance solely on indicators which wereprovided by firms themselves and which were, in themselves, dense, incomplete andinadequate. The complexity of the deals and the relationships between the differentlogics of financial instruments were not well understood and certainly had graveunintended consequences. It is apparent that “independent risk assessments” areinadequate and ineffective. Years ago, when huge losses flowed from securities whose

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issuers had misrepresented their risks, the reformist demand arose that someoneshould “independently” assess their risk so investors would be honestly informed. Itturns out now that providers of such independent assessments can misrepresent themas disastrously as their issuers did and do. More fundamentally, it reveals a blinkeredideology – market fundamentalism – at work. For example, Alan Greenspan inaddressing the Futures Industry Association in March 1999 insisted that any newregulations on derivative products “would be a major mistake”: “Regulatoryrisk-measurement schemes”, he added, “are simpler and much less accurate thanbanks’ [own] risk-measurement models” (Schwartz and Creswell, 2008). Appearingrecently before the US Congress, Greenspan admitted to having made mistakes, beingan ideologue with a misplaced faith in the ability of markets to self-regulate. Similarly,the clauses of Basel II that allow banks to use their own valuation models need to bestruck down.

Financialisation, as I have indicated, privatises information that should be public,just as it commercializes everyday life. In addition, the techniques of financialisationcould convert one type of income stream into another, or an asset into income or theother way round – reducing or avoiding tax. There are already calls for properregulation and registration of these instruments. Would governments and regulationdo any better? I think not. It is worth recalling that financialisation was born in a quiteheavily regulated world, with some of its techniques designed to frustrate and defeatthe regulators, just as others aimed at releasing “value” (Tett, 2007). As such, as a firststep, the clauses of Basel II that allow banks to use their own valuation models need tobe struck down before we address other pressing issues.

Most prescriptions for more regulation call for a new regulatory order where thestate is a more active agent. This involves a network of mechanisms designed toconstrain collective outbreaks of financial imprudence before they become global. Forexample, it has been suggested that there needs to be a new system of globallycoordinated financial regulation (Eatwell and Taylor, 2000). How and what this newregulatory framework should do, however, remains unknown for the fundamentalproblem remains: full and complete information, transparency and greater democraticaccountability, to which the corporate sector will not readily agree[16]. Governmentssimilarly would not be able to provide such access as privacy and commercialinformation enables corporations to “protect” such information. We need therefore tobe more sceptical of merely pushing for regulation, financial performance indicatorsand seek to deconstruct them. Similarly, calls for moral restraints and greater moralityin business may lead to various institutional designs and strategies to buildself-restraint in organisations and whilst certainly an important aspect of “regulating”corporate capitalism, such “moralism” fails to appreciate that “conduct” cannot bedivorced from the wider context of social and economic power.

The actual and potential costs of the credit crunch are already huge, but they mustbe seen as part and parcel of the rhythm of financialised capitalism. The solution to thehuge problems outlined above is not to abandon money or finance but to embed themin a properly regulated system. When properly embedded in structures of socialcontrol, finance can help to allocate capital, facilitate investment and smooth demand.But if it is unaccountable and unregulated it becomes sovereign in the reallocationprocess, and can grab the lion’s share of the gains it makes possible, includinganticipated gains before they have been realised. The problem is aggravated as


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financial intermediaries proliferate and take advantage of asymmetries in access toinformation and power imbalances. Such distortions multiply as “financialisation”takes hold. It is boosted as the logic of finance becomes ubiquitous, feeding on acommodification of every aspect of life and the life-course – student loans, baby bonds,mortgages, home equity release, credit-card debt, health insurance, individualisedpension funds (Martin, 2002).

The issues canvassed here are clearly political issues and a return to the political isnecessary if reforms are to be effective. Debates about corporations, the market, the stateand their attendant effects need to be revisited. This would result in more regulation likethe neoliberal governance response to Enron; its efficacy cannot be assumed and needsto be questioned and challenged (Soederberg, 2008). On a more mundane level, thisrequires greater elements of cooperation, collaboration and contestation of ideas withinand across locales and countries. The financial crisis has brought forth a coalition of theunwilling with strange bedfellows and the task for critical scholars and practitioners isto ensure the process continues to influence the “new” centres of power that now claim torepresent the interests of the people. This necessitates control, transformation,democratisation and a makeover of finance capital and the restoration and creation of“new” collective public services and infrastructures.

Notes

1. Despite knowing of the credit crunch in 2007 and dropping profits and share prices, seniorexecutives were still awarded handsome pay-offs by their boards of directors. The CEOs oftwo Wall Street banks left their jobs in 2007 clutching lavish rewards for failure: $160 millionfor Stanley O’Neal at Merrill and $90 million for Charles Prince at Citigroup. At Bear Stearnsthe rescue left shareholders with $10 a share compared with $170 a year earlier. One-third ofthe bank’s shares were held by its employees, many of whom will also lose their jobs. Boardmembers lost heavily on their holdings, but will remain very rich men since during the greatCDO bonanza – in which their bank was a lead player – they had earned fees and bonuses oftens, or even hundreds, of millions. Morgan Stanley also announced a $9.4 billion loss in thelast quarter of 2007 but still increased the size of its bonus pool by 18 per cent, arguing thatthe losses had been concentrated in structured finance and should not blight the rewards ofthose who continued to be profitable. Employee compensation generally runs at 50 per centof an investment bank’s revenue. In 2007 this rose sharply and in some cases came close to100 per cent (Rajan, 2008).

2. Thousands of mortgages would be consolidated into one instrument and the resulting poolof debt subdivided into ten tranches, each representing a claim on the income accruing to theunderlying mortgages; the lowest tranche represented the first to default, the second the nextpoorest-paying assets and so on up to the senior levels which were least likely to default. Thedifferent tranches’ vulnerability to default was hedged by taking out insurance, at ratesvarying according to the perceived level of default risk. Note that a feature of the securitisingand tranching process is that the holders of a tranche would not know which specificmortgages they held until the default rate within a specified period became clear.

3. The reasons for this are complex having to do with the maturation of economies, in whichthe basic industrial structure no longer needs to be built up from scratch but simplyreproduced (and thus can be normally funded out of depreciation allowances); the absencefor long periods of any new technology that generates epoch-making stimulation andtransformation of the economy such as with the introduction of the automobile (even thewidespread use of computers and the internet has not had the stimulating effect on theeconomy of earlier transformative technologies); growing inequality of income and wealth,

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which limits consumption demand at the bottom of the economy, and tends to reduceinvestment as unused productive capacity builds up and as the wealthy speculate more withtheir funds instead of investing in the “real” economy – the goods and services producingsectors; and a process of monopolisation (oligopolisation), leading to an attenuation of pricecompetition – usually considered to be the main force accounting for the flexibility anddynamism of the system.

4. Although this behaviour of the banks goes far beyond all such activities, it is not unique. In abook published in 1974, called The Bankers, the author Martin Mayer criticised the banks forover-extending themselves.

5. In April 2008, the International Monetary Fund (2008, p. 12) was estimating that total losseswere likely to come to $945 billion: “Global banks are likely to shoulder roughly half ofaggregate potential losses, totalling from $440 billion to $510 billion, with insurancecompanies, pension funds, money-market funds, hedge funds and other institutionalinvestors accounting for the balance”.

6. This is most evident in financial trading particularly through trading in foreign exchangemarkets and in derivatives. A New York Times (NYT) report noted that in 2006, the financialsector’s share of total corporate profits in the USA rose from 8 percent in 1950 to 31 percentin 2006 (New York Times, 11 December 2007)

7. There are a number of studies linking financialisation, neoliberalism and dollar hegemony.See for example, Harvey (2005), Glyn (2006) and Phillips (2006, 2008).

8. David Harvey (2005) sees this process as a process of accumulation by dispossessionthrough which working people are divested of their rights and assets, for example, theprivatization of water, health care and education, goods that had been or should beentitlements. The sale of these “goods” in private markets dispossessed those who could notafford what should have been theirs by right. At the global level, this has resulted in loss ofgovernment benefits, dispossessing people through debt repayment and the liberalisation ofthe local economy to benefit foreign investors and domestic elites.

9. Ironically, as Martin Wolf (2006) has shown, the economy grew twice as fast in the goldenage (circa 1945-1873) as in the succeeding era of globalisation. See also the more scholarlywork of Maddison (2001).

10. Beginning in January 2001, the Federal Reserve Board lowered interest rates in 12 successiverate cuts, reducing the key federal funds rate from 6 percent down to a post-Second WorldWar low of 1 percent by June 2003. Low interest rates tempted many homeowners to godeeper into hock by re-mortgaging. As Robert Brenner (2006) showed, the asset bubbles –first technology shares and then houses – helped to maintain the mirage of a buoyanteconomy and consumption growth, but only at the cost of growing personal and corporateindebtedness. This expanded the number of mortgage borrowers despite the increasingprices of houses. Many of these mortgage loans amounted to 100 percent of the appraisedvalue of the house and could only be sustainable as long as house prices continued to riseand rates remained low. Heavy borrowing is, as such, used to buy up financial assets, notbased on the income streams they will generate but merely on the assumption of increasingprices for these assets.

11. In a recent book, Fleckenstein and Sheehan (2008) have critically appraised AlanGreenspan’s tenure at the Federal Reserve. In their view, many bad decisions were enacted,contrary to popular belief: for example, the stock market crash of 1987; the Savings AndLoan crisis; the collapse of Long Term Capital Management; the tech bubble of 2000 and thecredit bubble and real estate crisis of 2007.

12. Michael Moran, for example, has pointed out that there is a long history of popular protestand discontent triggered by financial scandals and crises in the USA and that far from


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undermining the institutional and regulatory basis of financial expansion, have repeatedlybeen “pacified” through the process of further “codification, institutionalisation andjuridification” (Moran, 1991, p. 13). Furthermore, financial elites have been adept atresponding to these pressures and able to use them to create regulatory frameworksbeneficial to them.

13. In October 1907, a hundred years before the onset of the current subprime crisis, the USAexperienced an 11 percent decline in GDP and accelerating runs on it banks (Studenski andKrooss, 1965; Chernow, 1990). In the absence of a central bank, the US treasury and WallStreet relied on J.P. Morgan to organise the bailout. As Henry Paulson had done, Morgan letthe giant Knickerbocker Trust go under in spite of its holding $50million of deposits for17,000 depositors, fuelling further runs and panic. Finally, using $25 million provided byTreasury and a similar amount provided by Wall Street, Morgan then dispensed theliquidity to calm the markets (Chernow, 1990, pp. 123-5). This chain of events is notdissimilar to what is currently happening in the USA.

14. Quantitative economists, however, continue to naively believe in a simple numericaldiscount rate which can be used to calculate the net present value of a future stream ofincome or payments. This flattening process – also brought on by “mark to market” and“fair value” accounting – robs the future of its most unsettling characteristics: it is at onceunpredictable and carries the past within it.

15. Morgan Stanley compared the rate of downgrades in 2006-2007 to the historical norm for1998- 2006. The results are stunning. Among AAA-rated subprime residentialmortgage-backed securities, 4 per cent were downgraded (whereas the historical normwas 0.12 per cent). Among AA rated securities, 12.2 per cent were downgraded (versus anhistorical norm of 0.64 per cent). Of securities rated A and below, some 97 per centexperienced downgrades (versus the historical norm of 1.24 per cent).

16. George Soros (2008) calls for “a clearing house or exchange with a sound capital structureand strict margin requirements to which all existing and future contracts would have to besubmitted”.

References

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Brenner, R. (2002), The Boom and the Bubble, Verso, London.

Brenner, R. (2006), The Economics of Global Turbulence: The Advanced Capitalist Economiesfrom Long Boom to Long Downturn, 1945-2005, Verso, London.

Buenza, D. and Stark, D. (2004), “Tools of the trade: the socio-technology of arbitrage in a WallStreet trading room”, Industrial and Corporate Change, Vol. 13 No. 2, pp. 369-400.

Bukharin, N. (1929), Imperialism and World Economy, Merlin Press, London.

Chernow, R. (1990), The House of Morgan, Simon & Schuster, New York, NY.

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Doria, J., Rozanski, H. and Cohen, E. (2003), “What business needs from business schools”,Strategy and Business, Vol. 32, pp. 39-45.

Eatwell, J. and Taylor, L. (2000), Global Finance at Risk: The Case for International Regulation,Polity Press, Cambridge.

Ferguson, N. (2008), “Full Marx”, Financial Times, 17-18 August.

Fleckenstein, W. and Sheehan, F. (2008), Greenspan’s Bubbles: The Age of Ignorance at theFederal Reserve, Wiley, New York, NY.

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Ghoshal, S. (2005), “Bad management theories are destroying good management practices”,Academy of Management Learning & Education, Vol. 4 No. 1, pp. 75-91.

Glyn, A. (2006), Capitalism Unleashed, Oxford University Press, Oxford.

Gosling, J. and Mintzberg, H. (2006), “Management education as if both matter”, ManagementLearning, Vol. 37 No. 4, pp. 419-28.

Gray, J. (2008), “A shattering moment in America’s fall from power”, Sunday Observer,29 September.

Harvey, D. (2005), A Brief History of Neoliberalism, Oxford University Press, Oxford.

Hettenhouse, G.W. (1998), “The new MBA: a journey just begun”, Business Horizons, Vol. 41No. 4, pp. 45-8.

Ingham, G. (2004), The Nature of Money, Oxford University Press, Oxford.

International Monetary Fund (2008), Global Financial Stability Report: Containing Systemic Risksand Restoring Financial Soundness, International Monetary Fund, Washington, DC,available at: www.asiaing.com/global-financial-stability-report-2008.html (accessed 30 July2008).

Laing, J. (2007), “Failing grade”, Barron’s Magazine, 24 December.

Liang, N. and Wang, J.Q. (2004), “Implicit mental models in teaching cases: an empirical study ofpopular MBA cases in the United States and China”, Academy of Management Learning& Education, Vol. 34, pp. 397-413.

Maddison, A. (2001), The World Economy: A Millennial Perspective, OECD, Paris.

Magdoff, H. and Sweezy, P.M. (1983), “Production and finance”, Monthly Review, Vol. 35 No. 1,pp. 11-12.

Martin, R. (2002), The Financialization of Daily Life, Temple University Press, Philadelphia, PA.

Marx, K. (1909), Capital, Vols 1-3, Charles H. Kerr, Chicago, IL.

Mintzberg, H. (2004), Managers not MBAs: A Hard Look at the Soft Practices of Managing andManagement Development, Berrett-Koehler, San Francisco, CA.

Mintzberg, H. and Gosling, J. (2002), “Reality programming for MBAs”, Strategy and Business,Vol. 26 No. 1, pp. 28-31.

Mitroff, I.I. and Churchman, C.W. (1992), “Debate – MBA: is the traditional model doomed?”,Harvard Business Review, Vol. 70 No. 6, pp. 128-40.

Moran, M. (1991), The Politics of the Financial Services Revolution, Macmillan, New York, NY.

Palley, T.I. (2007), “Financialization: what it is and why it matters”, Working Paper Series,No. 153, November, Political Economy Research Institute, available at: www.peri.umass.edu/Publication.236 þ M505d3f0bd8c.0.html

Pfeffer, J. and Fong, C.T. (2002), “The end of business schools? Less success than meets the eye”,Academy of Management Learning and Education, Vol. 1 No. 1, pp. 78-96.


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Pfeffer, J. and Fong, C. (2004), “The business school ‘business’: some lessons from the USexperience”, Journal of Management Studies, Vol. 41 No. 8, pp. 1503-20.

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Shiller, R. (2008), The Subprime Solution: How Today’s Global Financial Crisis Happened, andWhat to Do about It, Princeton University Press, Princeton, NJ.

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Further reading

Allen, F. and Gorton, G. (1993), “Churning bubbles”, Review of Economic Studies, Vol. 60 No. 4,pp. 813-36.

Blackburn, R. (2008), “The subprime crisis”, New Left Review, March/April, available at: www.newleftreview.org/?view ¼ 2715 (accessed 30 September 2008).

Bruner, R. and Carr, S.D. (2007), Panic of 1907: Lessons Learned from the Market’s PerfectStorm, Wiley, New York, NY.

Bryan, D. and Rafferty, M. (2006), Capitalism with Derivatives: A Political Economy of FinancialDerivatives, Capital and Class, Palgrave, London.

Hirst, P. and Thompson, G. (1996), Globalisation in Question, Polity Press, Cambridge.

Holzer, B. and Millo, Y. (2005), “From risks to second-order dangers in financial markets:unintended consequences of risk-management systems”, New Political Economy, Vol. 10No. 2, pp. 223-45.

Jackson, T. (2007), “Crazy crisis may herald the end of new derivative folly”, Financial Times,24 December.

Kindleberger, C. and Aliber, R. (2005), Manias, Panics, and Crashes, Wiley, Hoboken, NJ.

Labaton, S. (2008), “SEC concedes oversight flaws fueled collapse”, New York Times,26 September.

Maddison, A. (1991), Dynamic Forces in Capitalist Development: A Long-run Comparative View,Oxford University Press, Oxford.

Magdoff, H. and Sweezy, P.M. (1988), The Irreversible Crisis, Monthly Review Press, New York,NY.

Orhangazi, O. (2007), “Financialization and capital accumulation in the non-financial corporatesector”, Working Paper Series, No. 149, October, Political Economy Research Institute,available at: www.peri.umass.edu/Publication.236 þ M547c453b405.0.html

Shiller, R. (2006), Irrational Exuberance, Doubleday, New York, NY.

Sunderland, R. (2008), “Now is our chance to change capitalism for good. Let’s take it”,Sunday Observer, 28 September.

About the authorLoong Wong works at the University of Canberra, Australia. He has taught and researched atuniversities in Australia, Denmark, New Zealand and Malaysia. His research has focused oninternational business practices and he has published in the Journal of Contemporary Asia, AsianBusiness and Management, Chinese Management Studies, Prometheus, and Information Societyamongst others. He is also active in a range of public interest and social movements. LoongWong can be contacted at: [email protected]


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Financial crisis, activist statesand (missed) opportunities

Federico CaprottiDepartment of Geography, University College London, London, UK

Abstract

Purpose – This article seeks to discuss three key issues raised by the recent financial crisis: the riseof “activist states”; a new focus on the geopolitical effects of finance; and possible future socialimplications of the rapid response to crisis.

Design/methodology/approach – The paper provides an analytical overview of three of theimplications of the current crisis, and introduces the idea of the “activist state” in financial markets.

Findings – The article focuses on three issues raised in connection with the recent crisis: the rapidrise of “activist states” as a result of impaired liquidity; the bringing to light of long-neglectedgeopolitical spaces of finance; and the opportunities for improved social aims communication andlobbying which result from future analyses of responses to the crisis.

Originality/value – The article’s focus is on the interface between finance and politics. The articleintroduces the idea of a financial “activist state” as a public entity which behaves like an activistshareholder in the market. The article also suggests that the political and banking reaction to thecurrent crisis can be seen in terms of opportunities to improve communication of social, political andpolicy aims in the future.

Keywords Recession, Financial markets, Credit, International business, Communication


Introduction: activist states, new fractures, and (missed) opportunitiesThe current financial crisis is far from over. Shocks take years to work through thefinancial system, and it is hard to assess their far-reaching consequences beforedistance from the crisis period has been achieved. The aim of this commentary is not,therefore, to provide an overview of the crisis, as it is not possible to do so effectively atthis time. Rather, the aim here is to highlight some potentially new features at theinterface between finance and politics, and to suggest some ways in which financialprofessionals, and the political reaction to the current crisis, can be seen in terms ofopportunities to improve future social, political and policy aims.

This short piece focuses on just three issues connected with the recent crisis:

(1) the rapid rise of “activist” states as a result of impaired liquidity;

(2) the bringing to light of long-neglected geopolitical spaces of finance; and

(3) the multiple (missed) opportunities evidenced by the loud and increasinglyhigh-pitched voices of the banking and political world in calling for hundreds ofbillions of dollars to be poured into the financial system in the form of“bail-outs”, loans, and credit.

What is meant by “(missed) opportunities” here is the ready availability of capital andresources to rescue the “financial system”, while much smaller capital and resourceallocations required to help resolve or ameliorate lasting socioeconomic problems,especially at the domestic scale, have regularly not been made available, or have been



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voted down by political representatives concerned with constituency reactions (Weiret al., 1988).

The sense of crisis, in other words, has legitimised demands on taxpayers. Thesedemands dwarf previous requests, by less powerful actors and social groups, focusedon a variety of social and policy issues. This commentary argues that a critical analysisof the mechanisms through which various actors (lobbyists, policy institutions,politicians, and players in the financial industry themselves) readily and powerfullycoalesced around an emergent discourse of financial crisis could lead to a progressiveand constructive understanding of mechanisms needed to mobilise resources andcapital around other, more long-standing but equally pressing issues.

The state: a new activist shareholder?The first point made by this commentary is that recent events in the financial marketsshould cause business leaders and scholars alike to rethink the way in which the stateis conceived vis a vis markets generally, and private firms specifically. This is due tothe wider repercussions of the financial crisis in other industrial sectors, as well as inpolitical life, and the action which governments have taken to mitigate these effects. Itis precisely these reactions that signal a re-engagement of the state with the market, ina readjustment (or, as some would argue, stabilisation) of neoliberal forms ofgovernance (Bakker, 2005).

The dust raised from the current crisis has not settled. It is therefore hard to providea comprehensive description, in this short space, of the various ways in which the stateis engaging in deeper ways with financial markets. However, it has become apparentthat states are, indeed, proactively and rapidly changing the ways in which theyinteract with financial firms. The recent crisis has seen national governments takeincreasingly large stakes in private companies. The motivation has been one ofpreserving these firms from potential failure, and stabilising the domestic financialmarket as a reaction to wider shocks stemming from problems with liquidity and creditmarkets. For example, at the time of writing, the British government was close toeffectively nationalizing Bradford & Bingley, Royal Bank of Scotland and HBOS, alarge UK mortgage and savings provider (Vina and Stirling, 2008; Kennedy, 2008).Northern Rock, an early casualty of the crisis, was nationalised in 2007.

This leads to the point that there exists an emerging landscape of state actors asactivist shareholders in financial firms. The notion of “activist states” has already beenapplied to states heavily involved in delivering social and health policies (Ramesh andHolliday, 2001; Biehl, 2001). This article extends the concept of the “activist state” tosignify those states which, through large stakes in financial firms, act increasingly likeactivist investors. This could be seen as a logical consequence of the fact that thefinancial industry is enmeshed with the rest of the economy, and, pari passu, with otherindustries and the diverse communities of citizens which make up the modern notion ofa state. Finance – as the credit crunch has painfully brought home to millions ofmortgage holders, savers and the energy poor – is deeply embedded in contemporary,everyday material life. At the same time, the economic landscape in question is nottop-down: everyday material life interacts with, and influences, the financial industry.

It comes as no great surprise that states are taking increasingly prominent stakes infinancial firms, and that some of these firms – Goldman Sachs and Morgan Stanleybeing the leading examples – are taking steps to re-regulate, stepping down to tighter

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regulatory controls. It may be argued that this has happened before, such as withSpain’s boosting of European regulations on Structured Investment Vehicles (SIVs)after a domestic banking crisis (Tett, 2008). However, the difference in 2008 is, firstly,that multiple states are taking unilateral steps to re-regulate. Secondly, they are doingso rapidly and decisively – if decisiveness is the right word in an economic climate inwhich a week’s delay on the proposed $700bn bail-out of US banks in early Octobercaused the Dow Jones to lose a record amount (800 points) in a single day. As JoseVinals, Deputy Director of the Banco de Espana, stated in a recent panel given to theIESE and Harvard Business Schools:

[T]he global banking system is continuously evolving within what is known as the “newglobal financial landscape”. This is characterised by several features: free internationalcapital flows, global financial markets and global banks, faster transmission of risks from onearea to another, and potential cross border contagion effects. In this context, some newproducts of increasing complexity, many of them derivatives, are being introduced. We arealso observing new players such as hedge funds, private equity funds, conduits, SIVs, etc.,whose actions are less and less transparent and subject to little or no regulation (Vinals, 2008,pp. 4-5).

A new player in this evolving landscape is the activist state. Just as activistshareholders act to shape a company’s direction, aims and board, so the activist stateaims to shape the direction of precisely those institutions – such as financial firms –which are crucial to national economies. Again, states have been taking stakes innational and international firms for a long time, through state-owned investmentvehicles which often behave like private equity firms – witness Temasek Holdings ofSingapore, the Abu Dhabi Investment Authority, or the China Investment Corporationin the People’s Republic of China. Furthermore, institutional investors retain majorholdings in financial firms (Gillan and Starks, 2003). However, it is again a question ofmultiple large-scale investment decisions being taken over a short period of time: at theend of October 2008, North American and European governments are much moredeeply and directly involved in financial firms than they had been just two monthsearlier. They have become activist investors.

As this piece goes to press, surprise is being expressed on all fronts at the fact thatgovernments are communicating views about firm development and directionfollowing the purchase of large stakes in these firms. This should not be shocking, leastof all to the business community: it is noteworthy, but not surprising, that states,having built positions which empower them to become activists, subsequently andincreasingly act like activist shareholders.

Geopolitical spatialities of financeThe crisis has also rippled over the margins of the financial world and has impacted onnational and international political power structures. For example, it has caused someunlikely alliances to appear and quickly dissolve. In the European Union, thegovernments of The Netherlands, Belgium and Luxembourg banded together in lateSeptember 2008 to inject $16.4bn into Fortis, a bank with cross-border operations in thesame countries. Within three weeks of this move, however, these governments hadmoved to dismember Fortis, with the Dutch government nationalizing Fortis’s Dutchbranch network (formerly ABN-AMRO), and the Belgian government planning to sell

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Fortis’s Belgian operations to investment bank BNP Paribas of France (Schwartz andDougherty, 2008).

Governments have also become involved – through their new roles as activistshareholders – in the trading of divisions of individual financial firms. For example,non-toxic parts of part-nationalised businesses are being traded by Europeangovernments, as is the case in the selling of Bradford & Bingley’s UK retail branchnetwork to Santander, a Spanish financial firm (Slater and Croft, 2008).

Finance has always been intimately tied in to politics and political power. Therecent crisis, the rise of activist states, and government involvement in taking overfinancial firms could, however, signal a shifting away from the dominant paradigmwhich has existed for the past 20 years. Since the early 1980s, there has been adecoupling, for want of a better expression, between the financial services industry andpolitics. Deregulation and privatisation (the hallmarks of a wider, neoliberal trend)became dominant economic paradigms. However, the crisis which started in 2007 hasbrought back to light those sunken links which unite political power with finance. Thepart-nationalisation of Icelandic banks in October 2008 – with the resultant potentialloss of non-domestic savers’ deposits in those same banks – was not a state action withsimple regional consequences. Rather, the regional crisis was followed by widergeopolitical ripples. Thus, at the regional scale, Britain and Iceland clasheddiplomatically, with tense negotiations undertaken through their respective treasuries;the situation was closely followed in both countries’ media. Furthermore, Iceland’sdeposit guarantee scheme called on reciprocal guarantee arrangements with otherNordic countries in order to guarantee domestic deposits. However, the guarantee wasnot extended to foreign (mainly British) depositors in newly globalised Icelandic banks.At a supra-regional geopolitical scale, the Icelandic government saw itself in theunprecedented position of having to petition to obtain a $4bn loan from Russia in thefirst week of October.

This brief example shows how the financial landscape, and markets themselves, areincreasingly losing their status as spheres of economic action supposedly separatefrom geopolitical upheavals. The financial crisis has therefore highlighted a whole setof relations and links between finance and domestic and international politics. Theselinks and feedback loops have to be taken into account from now on when consideringthe financial and socio-political landscape of the post-crisis system: the world is clearlyno longer flat (Friedman, 2006), but distinctly hilly.

Conclusion: (missed) opportunities?So far, the financial crisis has raised many questions; few answers have been provided.Several queries about the current crisis remain to be answered, including the extent towhich lack of liquidity and reduced market demand will determine the slide intorecession of several countries and regions of the globe. The regulatory landscape whichwill emerge out of the crisis is still the subject of active debate, as is the efficiency ofcurrent risk management regimes within financial firms. Other, minor issues will alsoneed to be resolved, such as unlikely moves to cap executive pay, or introduce moreoversight within organisations. The reaction of certain firm typologies to the crisis isalso evolving at the time of writing, and how these firms weather this period ofinstability, will undoubtedly be the subject of much speculation now, and research later


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on. In particular, it will be of interest to analyse the reactions to the crisis of hedgefunds and private equity firms.

Within the absolute returns industry, risk arbitrage and “black box” hedge funds, aswell as value funds, will be affected by lack of liquidity, potential draw-downs, andcurrent short-term regulations against short-selling (admittedly, this last factor will notapply to many value-oriented hedge funds). Within private equity, the collapse in theavailability of cheap credit and the risk exposure engendered by large amounts ofleverage in the current climate put business models focused on short-term buyouts atrisk.

Future scenarios notwithstanding, a key consequence of the crisis has been theability of governments to rapidly mobilise unprecedented amounts of capital in aneffort to restore liquidity and market confidence. Plans by the US Treasury to inject$700bn into “bail-out” plans were quickly followed by European governments’ similarinjections of capital (albeit in smaller individual amounts) into the system at thenational scale. What is striking and new here is, first of all, speed. Response times havebeen measured in weeks rather than months or years. In the USA, the use of state fundswas agreed to within three weeks. In the UK, the timeline was faster, and moves on theisland were quickly echoed by similar interventions (or intentions to intervene)elsewhere. This commentary will leave it to others to argue whether this represents ascaling back of neoliberal tendencies towards minimal state involvement in industry.Rather, what is interesting is the speed with which a response to financial crisis wasengineered and put into place. Whether or not the planned bail-outs work, the reality isthat they were largely in place only four weeks after Lehman Brothers ceased to exist.This leads to the observation that the financial industry’s efforts to influence bothpublic opinion and political will were both intense and highly goal-oriented.Furthermore, this intense pressure – partly based on existing links and networksbetween finance and the treasury world – largely achieved its aims, and did so quickly.This, in turn, leads to two pointers, which this commentary concludes on.

First, the current state of crisis, and its clear depiction in the media as a scenario ofdomestic as well as international importance, coupled with the financial industry’spressures on the political sphere, is indicative of missed opportunities for the resolutionof social and other problems. Some of the key factors which led US and Europeanpoliticians to make public funds available for the rescue of industry are the rapidconstruction of a sense of burgeoning crisis, coupled with the fact that calls for the useof public funds were both naturalised and prescriptive. Firms’ communicationsassumed that bail-outs were the only rational responses possible, and therefore it wasnatural – according to this line of argument – that governments would make publicfunds available. The financial industry’s claims to citizens’ fiscal contributions weretherefore legitimised. This is not the case with other, more long-standing domestic andinternational social, political and medical issues – problems which are indeedcontinuing crises, but which do not affect transnational capital and therefore have littleor no hold on the media, or on bureaucrats and politicians working on governmentbudgets and funding allocations.

Some policies, and some causes, are clearly more worthy than others (Weir et al.,1988), and this commentator wonders what $700bn could do for public health systems,public education, malaria research, or even return-oriented funding ofmicro-enterprises in the developing world. Issues such as public health funding in

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the USA – a situation seen as crucial by over 60 per cent of Americans (Brett, 2007) –would clearly benefit from a $700bn injection. Although cash injections are hardly themost efficient ways to improve public health services or provide solutions to othersocial issues (reforms and efficiencies must also play their part), providing liquidity toameliorate less-than-visible social crises would be a great step forward. However, theaim of this commentary is not to lament missed opportunities, but to highlightpotential ways forward.

First, the quick and decisive response to the crisis should be used by businessleaders and by those involved in socio-economic advocacy and policy. Studying whathas worked in this crisis, in terms of communication between industry andgovernment, would help in the targeting of lines of communication with more socialaims. Secondly, analysing the strategies which brought the crisis to the forefront ofpublic opinion, and which naturalised the claims of financial firms to state funds, couldlead to more effective social campaigning for non-state actors, NGOs, andpolicymakers scrabbling for funds which politicians often describe as meagre andunavailable – but which, clearly, are not. The crisis has, therefore, provided clearopportunities for engagement for business leaders and social objectives advocates.Perhaps the rally needs to move into the boardroom.

References

Bakker, K. (2005), “Neoliberalizing nature? Market environmentalism in water supply in Englandand Wales”, Annals of the Association of American Geographers, Vol. 95 No. 3, pp. 542-65.

Biehl, J. (2001), “The activist state: global pharmaceuticals, Aids, and citizenship in Brazil”, SocialText, Vol. 22 No. 3, pp. 105-32.

Brett, A.S. (2007), “Two-tiered health care: a problematic double standard”, Archives of InternalMedicine, Vol. 167 No. 5, pp. 430-2.

Friedman, T.L. (2006), TheWorld Is Flat: A Brief History of the Twenty-First Century, Macmillan,London.

Gillan, S. and Starks, L.T. (2003), “Corporate governance, corporate ownership, and the role ofinstiutional investors: a global perspective”, Journal of Applied Finance, Vol. 13 No. 2,pp. 4-22.

Kennedy, S. (2008), “Bradford & Bingley nationalized by UK government: Santander taking onbranch network”, Market Watch, 29 September, available at: www.marketwatch.com/news/story/bradford–bingley-nationalized-uk/story.aspx?guid ¼ {FF8C6FD0-EE03-4E97-BA71-B2DF0C182C34}&dist ¼ msr_2 (accessed 12 October 2008).

Ramesh, M. and Holliday, I. (2001), “The health care miracle in East and Southeast Asia: activiststate provision in Hong Kong, Malaysia and Singapore”, Journal of Social Policy, Vol. 30No. 4, pp. 637-51.

Schwartz, N.D. and Dougherty, C. (2008), “Europeans handle crisis together and separately”,International Herald Tribune, 7 October, available at: www.iht.com/articles/2008/10/07/business/07euro.php (accessed 12 October 2008).

Slater, S. and Croft, A. (2008), “Santander buys B&B deposits as nationalization looms”, Reuters,29 September, available at: www.reuters.com/article/innovationNews/idUSTRE48Q1Z520080929 (accessed 12 October 2008).

Tett, G. (2008), “Time for central bankers to take Spanish lessons”, Financial Times,29 September, available at: www.ft.com/cms/s/0/1f50c5d4-8e65-11dd-9b46-0000779fd18c,dwp_uuid ¼ 86c92008-1c23-11dd-8bfc-000077b07658.html (accessed 12 October 2008).


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Vina, G. and Stirling, C. (2008), “Royal Bank of Scotland, HBOS set to be taken over bygovernment”, Bloomberg, 12 October, available at: www.bloomberg.com/apps/news?pid ¼ 20601102&sid ¼ aw6Y9TU3RioI&refer ¼ uk (accessed 12 October 2008).

Vinals, J. (2008), “The role of the Banco de Espana in Spanish banking”, panel presentation atIESE and Harvard Business Schools, 11 January, available at: www.bde.es/prensa/intervenpub/subgoberna/Sub110108e.pdf (accessed 12 October 2008).

Weir, M., Orloff, A.S. and Skocpol, T. (1988), “Understanding American social politics”, inWeir, M., Orloff, A.S. and Skocpol, T. (Eds), The Politics of Social Policy in the UnitedStates, Princeton University Press, Princeton, NJ, pp. 3-27.

About the authorFederico Caprotti is a faculty member at the Department of Geography, UCL. His currentresearch focuses on environmental discourse and factors which influence decision making infunding deals in the cleantech sector, with a particular interest in wind power deals in China, theUSA and the UK. He has previously worked for Oxford University and the University ofLeicester. Federico Caprotti can be contacted at: [email protected]

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The Kindleberger-Aliber-Minskyparadigm and the global subprime

mortgage meltdownWilliam V. Rapp

The New Jersey Institute of Technology, Newark, New Jersey, USA

Abstract

Purpose – This paper sets out to analyze the current global financial crisis that originated in the USsubprime mortgage market through the lens of the Kindleberger-Aliber-Minsky (KAM) paradigm asset forth in Kindleberger and Aliber’s Manias, Panics and Crashes, to first examine the bubble’sorigins in the displacement caused by the internet collapse, the subsequent US recession, and theaggressive lowering of US interest rates. It shows how these events, combined with other technologicaland regulatory factors, resulted in a US housing bubble fueled by the aggressive securitization ofmortgages by many large financial institutions, a reduction in their credit standards, and a lack ofregulatory oversight. In this way it assesses the prime players in the process in terms of motivationand performance.

Design/methodology/approach – The paper explores how the process peaked and began tounravel as cash flows at the base of the financial pyramid built through securitization slowed. Once thesupporting cash flow came under pressure and was questioned, several major players went bankruptor took tremendous losses. It became apparent that risk and innovation had been improperly balanced,a prime characteristic of the KAM paradigm. Indeed, greed, innovation, and technology had combinedto substantially reduce credit quality and increase leverage, vastly expanding the likelihood of aliquidity crisis and a substantial drop in the value of asset-backed securities.

Findings – The analysis then examines why this effect had significant global dimensions, unlike, forexample, the Japanese real estate and stock market collapse or the US internet boom and bust. Theanalysis also shows how market reactions have been in line with what might be expected under theKAM paradigm. It also conforms with what Robert Shiller and Edward Gramlich anticipated and withnormal bank behavior in a credit crisis.

Originality/value – The paper assesses the policy responses to the crisis and their likely successunder a KAM paradigm analysis. The proposed remedies already include the aggressive fiscal andlender of last resort monetary responses typical of the KAM paradigm but regulatory measures too.Further, as KAM notes, almost all booms and crashes involve scandals and scams. So not surprisinglythere has been growing recourse to the courts seeking criminal and civil remedies. Also typical of sucha dramatic boom and bust, governments are examining regulatory and legislative actions to addressthe current difficult economic and credit situation and to make sure that similar things do not occur inthe future. But politics and a US presidential election are driving significant differences in approach.Under these circumstances what can the lens of the KAM paradigm tell us about the actions taken orproposed and what is or is not likely to work?

Keywords Economic booms, Recession, Financial markets, Mortgage default, United States of America


IntroductionThis paper argues that the bubble paradigm explained in Manias, Panics and Crashes(Kindleberger and Aliber, 2005) applies to all aspects of the subprime mortgage crisisfrom development of the bubble through the legal, economic and political aftermath.Indeed any reasonable application of the paradigm should have raised early warnings



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critical perspectives on internationalbusiness

Vol. 5 No. 1/2, 2009pp. 85-93

q Emerald Group Publishing Limited1742-2043

DOI 10.1108/17422040910938703

about the housing bubble, its inherent risks and the likely wide scope and disastrousfinancial and economic impact of a collapse. Indeed, if used by policymakers to raisecautionary flags it could have served theirs and the public’s long-term interests.Further as the KAM paradigm predicts, the subprime mortgage meltdown and itsaftermath have brought numerous civil and criminal actions. For example, mortgagefraud in the USA, including Federal and state prosecution, is growing dramatically.Suspicious activity reports related to mortgage fraud increased over 1,000 percentbetween 1997 and 2005, and pending FBI mortgage fraud investigations rose from 436in fiscal 2002 to 1,210 in fiscal 2007 (Grant, 2008).

The huge increases in the US mortgage market and its increasing complexity haveopened many attractive opportunities for fraudsters across a range of financialactivities and institutions. The most common frauds involve “property flipping” orother schemes to get proceeds from mortgages or property sales via misleadingappraisals or false documentation. The SEC is also looking at insider trading related tounexpected write-downs by publicly traded companies with assets tied tomortgage-backed securities. Further, plaintiffs’ lawyers and their clients have beenactive in making other claims such as misrepresentation or failure to disclose materialsinformation, trying to recover some of the billions of dollars in losses. However, tograsp the subprime bubble and meltdown in its development, subsequent crash andcurrent aftershocks, one must first understand the key changes that occurred in thefinancial markets for mortgage-related securities and their legal underpinnings alongwith how changes in US banking and security laws have complicated the situation.

Structure and evolution of the US mortgage marketThe US residential mortgage market is a multi-trillion dollar market that has increaseddramatically over the last five years. In June 2007 residential and non-profit mortgagesoutstanding amounted to $10.143 trillion, up from $5.833 trillion as of September 2002(Federal Reserve Bank, 2007), and from $2.3 trillion in 1989 (Korngold and Goldstein,2002). In turn, the number of firms and organizations participating in this huge markethas proliferated. Traditionally, up until about 25 years ago home loans and mortgageswere usually arranged between a local bank or local savings and loan (S&L) and a localborrower with the bank or S&L holding the mortgage subject to local real estate lawsand land registry regulations until maturity or the home was sold or the mortgagerefinanced. But starting in the 1980s and expanding into the 1990s and the first yearsof this century, that all changed. Banks and S&Ls discovered the benefits ofsecuritization and balance sheet turnover. They realized mortgages and other regularpayment credit instruments such as auto loans and credit cards had steady cash flowsthat, if bundled, would provide investors with a steady income stream that could becapitalized and sold. This led to the concept of securitizing these cash flows.

Now banks and S&Ls, rather than holding the loans in portfolio as investments,bundled and sold them to investors while retaining the servicing function, for whichthey deducted fees. This innovation meant banks or S&Ls could rapidly turn over theirbalance sheets, since they did not have to wait until a loan was repaid or their capitalincreased to make new loans and expand revenues from loan servicing and originationfees. This process increased return on capital, earnings per share, and shareholdervalue, benefiting shareholders and corporate officers with stock options. In the 1980s,under the Basle agreements and Resolution Trust Corporation Act, banks and S&Ls

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were subject to more stringent capital requirements relative to loans they booked. Thisgave them an incentive to no longer hold loans to maturity or payoff. Rather, as justexplained, it made sense to package and sell them to long-term investors such asinsurance companies (Rapp, 2004).

As the new system evolved and became national or even international rather thanlocal, other financial intermediaries emerged that specialized in specific functionswithin the overall mortgage packaging and sale to investors’ business chain. Forexample, mortgage brokers realized they could sell a New York mortgage to aWashington S&L that might price it more aggressively on rate and term than a localbank. This could be due to the other lender’s lower funding costs, desire to diversifyrisk across more markets, or interest in expanding its servicing portfolio to achieveeconomies of scale. Indeed, it could be a combination of these factors. Brokers couldthus find borrowers the best rate within a competitive and integrated national marketfor residential mortgages that ultimately squeezed out the small local bank or S&L, amajor reason why they have been less affected by the credit crisis.

Further, as the market expanded, economies of scale in specialization at differentpoints in the mortgage financing and investment chain emerged. The development ofthe internet and computer power only increased such considerations as technologicalprogress created significant cost improvements in sourcing and processing mortgageapplications and approvals online. Just as a homebuyer could now virtually tourseveral houses in an afternoon without leaving home, they could compare mortgagerates from several sources, while lenders could quickly scan a buyer’s credit score.Similarly huge increases in computing power and telecommunications introducedeconomies of scale in servicing the mortgages (Rapp, 2004) and the investors. Underthis new and evolving structure it was quite possible no federally insured bank or S&Lwas involved in the loan or any one investor would hold the actual mortgage assecurity.

A mortgage broker could find a lender such as GMAC or GE Credit Services orMerrill Lynch instead of a traditional bank or S&L. These lenders would bundle themortgages into pools, usually as a trust, and either themselves or via investment bankssuch as Lehman Brothers or Bear Stearns place them with investors (Yamada andKubo, 2008). But rather than selling the pools or percentages of the pool to an insurancecompany, hedge fund, or structured investment vehicle (SIV), they sold pieces of thepool’s cash flow tailored to an investor’s requirements. Thus, long-term investorsmight only want the final monthly payments while another, shorter-term investor,might desire only the first three years’ interest. The longer dated monthly paymentswould then be sold to a different investor group. Thus no investor owned an entiremortgage and none were involved in the loan administration or handling of thesecurity. In “House of junk”, Fortune details a Goldman Sachs deal that highlightsthese considerations (Sloan, 2007).

Large computer systems supported the servicing of these different structures andfavored firms that could source and service in volume, spreading the system costs overa large number of mortgages, customers and structured investments. This led to afactory mentality in creating the pools, including the supporting legal documentation, apractice that has carried over to foreclosure activity in the current economic downturnand housing crisis (Morgenson and Glater, 2008). Because the initial lenders onlyexpected to hold the mortgages for a short period they frequently funded the initial


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mortgage loan using commercial paper. In addition to GMAC and GE, severalspecialized mortgage lenders used this technique, including those focused heavily onthe subprime mortgage market. In their 2005 annual reports GM and GE indicate thiskind of activity, and indeed GM indicated $4 billion in mortgage servicing rights on itsbalance sheet. The Countrywide Financial Corporation (CFC), perhaps the largestmortgage lender in the USA, did this extensively with its commercial paper backed byits mortgages (Countrywide Financial Corporation, 2007). It did this even though asubsidiary was a federally insured S&L. It continued this funding practice up until2006, probably to avoid the more stringent capital requirements the government hadimposed on S&Ls in 1989 as part of The Resolution Corporation Trust Act[1]. Thecollapse of the sub-prime market, though, has forced CFC to change its business model.In 2006 it applied for changed status to a Federally Regulated Savings and LoanHolding Company (Countrywide Financial Corporation, 2007).

Nevertheless, the size of the mortgage financing market, its rapid growth and itsincreasing complexity have combined with the current meltdown and the billions inlosses by financial institutions and investors, to create – as the KAM paradigm wouldexpect – many opportunities for legal actions, including criminal prosecutions forfraud and numerous civil actions seeking a legal remedy and some restitution of thelost billions (Hamilton, 2008). Not surprisingly, the points of legal altercation aregenerally at the intersections that represent handoffs of the loans and mortgagesbetween institutions such as the mortgage broker to the lender or between the lenderand the packager or the packager and an investor since these points have usually beenaccompanied by contractual documentation representing the warranties andresponsibilities of the party doing the handing off of the offering to the onereceiving or accepting the securities. These contractual obligations then become thebasis for any recovery. However, the cookie-cutter approach used to produce thesecurities on a mass production basis are now creating problems. This is because theslicing of loan pools into several pieces with varying rights to specific mortgagepayments, coupled with the multiplicity of documentation at each point in the chain,have combined with the split between servicing and ownership to make it unclear whocontrols the pool or the underlying mortgage loan and its payment stream. Indeed, inseveral cases the servicing agent holds the mortgage in trust for the pool, while thepool is controlled by the super senior tranche for a diverse group of investors withconflicting interests.

Kindleberger-Aliber-Minsky paradigmThis scenario’s boom and bust tracks the KAM paradigm perfectly. So predicting thebust and it consequences was not as difficult as Robert Rubin has posed. Indeed, in hisbook Subprime Mortgages, Edward Gramlich (2007) did exactly that. The KAMparadigm explains that every mania or bubble begins with some large displacementthat changes expectations, such as a major technical advance like thecommercialization of the internet, or rapid deregulation such as occurred in Japan inthe early 1980s or in the USA in 1999 with the repeal of Glass-Steagall underGramm-Leach-Bliley, or a large injection of liquidity such as occurred after the internetbust. In this case, it was mostly the huge increase in liquidity and lower interest rates,but this change built on and benefited from the other two. This was because theelimination of Glass-Steagall vastly increased the number of players while the internet

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boom had created tremendous and low-cost computing and communications powerthat, as described above, greatly facilitated and accelerated the credit expansion. Oncethe displacement has occurred related assets start to appreciate. This leads to theinteraction of greed, speculation and further asset appreciation, or a bubble thatcontinues to expand until the leverage fueling the system can no longer support furtherexpansion or price increases in the asset class.

Overly aggressive bank lending, though, is a critical aspect of the KAM paradigm,since it provides the leverage that fuels the expansion of the bubble on the upside andaccelerates the collapse on the downside as banks become more conservative relative torisk and begin to restrict credit. Here the banks’ over-lending to support the acquisitionand holding of mortgage-backed securities occurred directly to investors, indirectly vialending by hedge funds the banks funded, and also through various derivatives suchas credit default swaps (CDS). Since leverage for some investors reached over 40 to one,any glitch in the market could set off margin calls and the downward spiral of sales,price declines, and more margin calls that actually occurred, just as happened in 1929with respect to stocks.

Applying KAMKAM paradigm and subprime mortgage meltdown – dislocation and bubbleThis happened in the US mortgage market as housing prices rose faster than people’sincomes. At first lenders kept the process going through low interest “teaser” loans.But as the Fed tightened rates and mortgage interest reset at higher rates, foreclosuresbegan to rise and new homebuyers were priced out of the market. These developmentscaused lenders and investors to reassess the risks and to pull back on new money,leading to a drop in residential real estate values. Investors then had to reassess thevalue of their investments and the stage was set for a KAM panic as heavily leveragedinvestors tried to convert to cash. The flood of assets coming to market combined withdecreased demand due to risk reassessment and decreased credit availability broughtthe inevitable crash. No surprises here.

Crash; scandals and scams; political and legislative actionsThe crisis following the crash and the pattern of its aftermath also tracks KAMperfectly. As Kindleberger notes, historically almost every financial boom and bust isfollowed by a series of scandals (Kindleberger and Aliber, 2005). Since people areusually hurt by the collapse in asset values and especially those involving fraud, thereis usually political pressure to punish those perceived as having caused the problem aswell as to prevent future abuses even though the real reason for the boom is generallythe public’s greed, in this case using the equity in their homes like an ATM to fundconsumption. Still, the panic that follows the collapse as the bubble runs out ofliquidity to further support much less inflate asset prices frequently spurs “barn-doorclosing” legislation. The Federal Reserve, the SEC and Sarbanes-Oxley resulted fromthe financial crises of 1905, the crash of 1929 and the collapse of the internet bubblerespectively.

It is thus not surprising the US housing market bubble and its collapse, particularlyin the subprime mortgage market that was especially subject to broker and lenderabuse, has exposed similar bad practices such as predatory lending and no verificationmortgages. This, as KAM would expect, has lead to subsequent Congressional and Fed


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action. Indeed, the House has already passed legislation to address some of theseissues. Yet interestingly the new legislation just builds on the intent of Congress in its1989 legislation, stimulated by the prior LBO bubble collapse and S&L crisis,regarding loans secured by real estate needing to meet “standards as are consistentwith safe and sound business practices”[1]. Thus Congress’s response in 1989 and 1990to the S&L crisis and the junk bond scandals, when by enacting FIRREA itsubstantially increased and broadened penalties for crimes impacting financialinstitutions and tightened capital standards for banks and S&Ls, did little to moderate,much less prevent, the current crisis. Here one must lay some of the blame for thebubble on the Fed since the controls existed but for policy reasons were not used.

Examples of civil causes of action (Rapp, 2008)KAM predicts that a bubble’s collapse always leads to numerous lawsuits, and alreadymany have been filed: the City of Springfield and the Massachusetts Attorney Generalhave sued Merrill for misrepresenting the quality of subprime CDO investments andassociated risks. The City of Cleveland is suing 21 Ohio banks under Ohio’s PublicNuisance Law, accusing them of reckless lending that is placing a financial andadministrative burden on the City due to the high number of foreclosures (Hamilton,2008). Reflecting the international scope of the bubble and its collapse, the AustralianShire Council of Wingecarribee near Sydney is suing Lehman Brothers, arguing thatLehman improperly sold them risky mortgages. According to the Financial Times, thetown claims Lehman had “failed to act in the council’s best interest and engaged inmisleading and deceptive conduct while serving as its financial adviser and investmentmanager by promoting the Lehman-originated Federation CDO, which was exposed tothe US subprime market. Federation was last month marked down to 16 cents in thedollar”. The town’s representative claims “it relied on Lehman’s advice andrepresentations in making its investments”. (Fry, 2007).

Meanwhile Lehman is suing Fieldstone Investment Corporation for having soldthem “dubious” loans. Lehman claims borrowers’ income and the appraised homevalues were overstated and the conditions of the homes were poor. Their requestedremedy, which Fieldstone is resisting, is to buy back the problem loans. Similarly PMIGroup, a mortgage insurer, is suing subprime lender WMC in California to buy backloans PMI insured, claiming the latter “systematically” did not apply “soundunderwriting practices” and made the loans fraudulently or “in violation of thestandards that the lender said it was using” (Bajaj, 2008). As evidence for its position,the lawsuit states it hired a consultant to review the 5,000 loans in the mortgage pooland it found 120 were defective, of which WMC has only offered to buy back 14.

Countrywide’s shareholders have brought a suit in Federal Court in LA againstsome officers and directors claiming they turned a blind eye to deviations frommortgage underwriting standards. As part of their case, the “plaintiffs contend that theofficers and directors dumped shares even as the company spent $2.4 billion torepurchase its own stock in late 2006 and early 2007”. In his defense, the CEO, Mozilo,has claimed he had complied with the securities laws under a planned selling program.But the judge noted in denying his motion to dismiss that he had revised the programseveral times, each time increasing the shares to be sold, something the SECregulations do not allow (Morgenson, 2008).

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Investors in two hedge funds organized in the Cayman Islands that were feederfunds for a Bear Stearns master fund have successfully seized control of the feederfunds in a Cayman court by having their own liquidator appointed. The court saw themaster fund liquidator as having a conflict. The investors hope control of the feederfunds will give them standing to sue. The investors argued “that [Bear] generated andrelied upon erroneous net asset value calculations and that [Bear] ‘warehoused’ or‘dumped’ unrealizable [. . .] subprime debt in the feeder funds in contravention of theoffering memorandum”. Further, the judge ruled that Bear should share some of thecosts as “the bank was behind the decision to put the funds into liquidation ahead of apetition by investors to take control by electing their own directors” (Mackintosh,2008). In another breach of contract case, Merrill Lynch is suing XL Capital Assurance,a Security Capital Assurance owned subsidiary, for failing to meet its obligationsregarding $3.1 billion in credit default swaps (CDS). Merrill said, “We filed suit to makeclear that XL Capital Insurance Inc. is required to meets its contractual obligations forcredit default swaps it agreed to” (Charles Schwab, 2008).

Barclays Bank believes itself to be the victim of a hedge fund managed by BearStearns that irresponsibly invested investors’ money in complex subprime securities(Larsen and Murphy, 2007). HSH Nordbank, a state-controlled German bank, is suingUBS in US Federal court under New York law. It contends UBS improperly sold itcomplex collateralized debt obligations (CDOs) that it mismanaged. HSH asserts itsclaims based on “the manner in which the investments were sold to HSH Nordbank andUBS’s subsequent management of the assets [being] clearly contrary to [its] interests”.HSH claims UBS was supposed to manage the investment conservatively andprudently, but did not (Werdigier, 2008).

Under ERISA, managers of pension funds have a fiduciary responsibility to act inthe interests of their clients. Under a pending case, State Street Global Advisors, asubsidiary of State Street bank, has set aside $618 million to “settle claims that the firminvested in risky mortgage-related securities”, including those brought by five pensionplans. The pension clients claim State Street told them the funds “would be invested inrisk-free debt securities (e.g. Treasuries) but were used instead to acquire ‘high risk’investments and mortgage-backed securities”. ERISA requires “a prudent manstandard of care”. It appears State Street now recognizes that CDOs backed bysubprime mortgages do not meet this test.

Many mortgage lenders and underwriters have been accused of taking inadequatereserves or not properly accounting for returned mortgages pools or those held inportfolio even while delinquencies and foreclosures were rising. In one class action,Michael Atlas v. Accredited Home Lenders Holding Co. (WestLaw 80949, 2008), theplaintiffs allege Accredited and certain directors concealed the firm’s “true financialcondition and made materially false and misleading statements regarding thecompany’s operations and income”. Particularly, they cite the firm’s assertionsunderwriting standards for subprime borrowers were especially conservative andreserve policies for possible delinquent loans or repurchase obligations were more thanadequate. Further, the plaintiffs allege Accredited did not write down to fair valueproperties gained by foreclosure. Since, given these considerations, Accredited’sfinancial statements seem to have erroneously and artificially inflated income, theplaintiffs assert they have a course of action. The Federal Court in Southern Californiaagreed and denied Accredited’s motion to dismiss, noting a “prior auditor’s refusal


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during the class period to approve the company’s 2006 financial statements before thedeadline for filing its form 10-K, and the new auditor requiring the company to restateto increase its allowance for loan losses by over $30 million”.

Evaluating policy solutions and concluding recommendationsThe above analysis indicates the subprime mortgage crisis and its aftermath have inall respects followed the KAM paradigm. The bubble’s development and its causeswere recognizable as early as 2005 (Shiller, 2005; Gramlich, 2007). It was then that theFed should have used its regulatory and bank examiner powers to impose stricter bankcredit standards and greater capital allocations against such lending. If they had, thefinal mania might have been avoided and the collapse and its aftermath significantlymoderated. However, because this was not done, we now have a financial crisis ofglobal proportions with attendant impacts on the US and world economies.

So what should be done to address these issues in the short to longer term? Recentlender of last resort actions the Fed and other central banks have taken to assuremarket liquidity as per KAM seem appropriate and directly address the fact this crisis,unlike Japan’s real estate crisis or the USA’s internet bubble, is global in scope and hasseriously affected world credit markets, including inter-bank lending. This is a directresult of the deregulation and globalization of financial markets during the 1990s andthe early part of the twenty-first century. Further Glass-Steagall’s repeal meantinvestment banks particularly became major players in packaging and distributingthese products globally, along with related instruments such as credit default swapsthat magnified the risks of any downturn. Therefore in the medium term the Fed andother regulatory bodies need to examine ways to increase the transparency anddecrease the leverage inherent in these financial products and the institutions thatcreate and distribute them, insisting on a greater appreciation and valuation of therelated risks, especially if the investment banks want and need greater access to centralbank credit. In addition, Congress and the Administration need to take measures toreduce the over-supply of housing and the possible cascading downward spiral offoreclosures and falling home prices that are seriously affecting the real economyincluding rising unemployment and a possible recession. Fiscal and monetary policyalone will not do the trick.

There is also a longer-term policy requirement. Over-confidence in laissez-fairemarket-based solutions has already resulted in two large asset bubbles with adverseeconomic consequences. Therefore, as already initiated by the Fed and the USTreasury, there is a need to assess and develop regulations and policy responses tounwarranted asset inflation. The KAM paradigm is a useful place to begin thisassessment, both in terms of identifying when a rapid rise in asset prices is indeed abubble and in developing the appropriate responses for which transparency and microregulatory actions may be more appropriate moderating actions to growing systemrisks than macro monetary and fiscal policies.

Note

1. Financial Institutions Reform, Recovery, And Enforcement Act Of 1989, P.L. 101-73 orFIRREA, pp. 3-4.

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References

Bajaj, V. (2008), “If everyone’s finger-pointing, who’s to blame?”, New York Times, January 22.

Charles Schwab (2008), online market comments, available at: www.schwab.com

Countrywide Financial Corporation (2007), Annual Report 2006, Countrywide FinancialCorporation, Calabasas, CA.

Federal Reserve Bank (2007), available at: www.federalreserve.gov/datadownload/Review

Fry, E. (2007), “Lehman faces lawsuit over CDO losses”, Financial Times, December 21.

Gramlich, E. (2007), Subprime Mortgage Crisis, Urban Institute Press, Washington, DC.

Grant, J. (2008), “FBI opens subprime fraud inquiries”, Financial Times, January 30.

Hamilton, W. (2008), “Lawyers smell opportunity as subprime suits start to boom”, Los AngelesTimes, March 16.

Kindleberger, C. and Aliber, R. (2005), Manias, Panics and Crashes, Wiley, Hoboken, NJ.

Korngold, G. and Goldstein, P. (2002), Real Estate Transactions, Foundation Press, New York,NY.

Larsen, P. and Murphy, M. (2007), “Barclay’s ready for subprime fight”, Financial Times,December 21.

Mackintosh, J. (2008), “Rebel investors seize Bear Stearns hedge funds”, Financial Times,February 29.

Morgenson, G. (2008), “Judge says countrywide officers must face suit by shareholders”,New York Times, May 15.

Morgenson, G. and Glater, J. (2008), “The foreclosure machine”, New York Times, March 30.

Rapp, W. (2004), Information Technology Strategies, Oxford University Press, New York, NY.

Rapp, W. (2008), “Civil causes of action and the sub-prime mortgage meltdown”, working paper,available at: [email protected]

Shiller, R. (2005), Irrational Exuberance, Currency Doubleday, New York, NY.

Sloan, A. (2007), “House of junk”, Fortune Magazine, October 16.

Werdigier, J. (2008), “Faulting UBS for its losses in bad debt, a client is to sue”, New York Times.

Yamada, Y. and Kubo, T. (2008), Japanese Major Banks, Merrill Lynch Japan Securities, Tokyo.

About the authorWilliam V. Rapp is the Henry J. Leir Professor of International Business at the New JerseyInstitute of Technology’s School of Management. William Rapp can be contacted at: [email protected]


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Wrong assumptions in thefinancial crisis

Manuel B. AalbersAmsterdam Institute for Metropolitan and International Development Studies,

University of Amsterdam, Amsterdam, The Netherlands

Abstract

Purpose – The purpose of this paper is to show how some of the assumptions about the currentfinancial crisis are wrong because they misunderstand what takes place in the mortgage market.

Design/methodology/approach – The paper discusses four wrong assumptions: one related toregulation, one to leveraging, one to subprime lending and one to predatory lending. It brieflydiscusses some policy implications.

Findings – The role of the state in the mortgage market is more complex than suggested by thosewho blame the state for not doing anything. The concept of leveraging can explain, at least in part,why the losses in financial markets are bigger than the losses in the housing market. Many subprimeloans were sold to prime borrowers. Subprime lending was not designed to increase homeownershiprates, but to fuel profits by exploiting vulnerable borrowers.

Practical implications – It is too easy to argue that everyone made mistakes; most borrowerscannot be blamed for being sold risky, overpriced loans. A rescue plan is needed for defaultingborrowers and those already in foreclosure.

Originality/value – The paper does not present new research, but brings together research thatdemonstrates that the roots of the crisis in the mortgage market are in many ways different from whatis suggested by professionals and journalists alike.

Keywords Recession, Credit, Mortgage default, Loans, Regulation, United States of America


The current financial crises is presented as one in which homeowners took out riskyloans that were pushed by greedy loan brokers and lenders who didn’t care about theriskiness of these loans as they would be packaged and sold off as residentialmortgage-backed securities (RMBS) anyway. It continues to present a network ofagents that have not paid enough attention to risk: not only borrowers and lenders, butalso the state, regulators, investors and rating agencies. This image of the roots of thefinancial crisis is not wrong, but it is limited in explaining what went wrong. In thisshort contribution I will discuss four wrong assumptions in discussions on the roots ofthe financial crisis in the mortgage market.

First, it is too easy to argue that the state and regulators were not acting. The statehas enabled both securitization and subprime lending (Aalbers, 2008; Immergluck,2009). Gotham (2006) has studied the deregulation of the mortgage market anddemonstrates how the federal government, step-by-step, has enabled securitization, forexample by the Financial Institutions Reform, Recovery and Enforcement Act (1989),which pushed portfolio lenders to securitize their loans and shift to off-balance lending.In other words, the state was at the origins of the current crisis. Many regulators havedone too little, because they either were heavily understaffed or assumed financialmarkets could work most efficiently if they were be self-regulated. More importantly,since the 1990s most mortgage lenders were non-banks that did not have to live up to



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banking regulations and could operate within an almost non-existent framework. Onthe other hand, several American states such as North Carolina and West Virginiaintroduced additional state regulation. In 2003, four years before the crisis, New Mexicoeven introduced a Home Loan Protection Act. Yet, many state initiatives were blockedby the federal government and states were forced to withdraw certain acts andregulations. Something similar happened on a lower level. In Ohio, the City ofCleveland, which includes the zip code with the highest number of foreclosures in thecountry and had already had a foreclosure crisis since the beginning of this century,tried to introduce local regulation to make abusive lending practices more difficult, butgot into trouble with Ohio State as the latter argued that it was not the City’sresponsibility to come up with financial regulation. In other words, we cannot say thatthe state did not do anything: while some state institutions enabled securitization andsubprime lending by implementing “facilitating laws” and by ignoring their regulatoryresponsibilities, other state institutions tried, often unsuccessfully, to combat thenegative aspects of the new financial regime.

Second, the idea that “everyone is guilty” does not really explain why losses in thefinancial markets run into hundreds of billions and perhaps even one to two trillion USdollars worldwide. How could a national house price decline of 20 per cent cause suchbig losses for investors involved in RMBS? The short answer is leveraging. Becausemany investors, such as investment banks, bought RMBS with borrowed money, boththe profits and the losses would be disproportionately large. A leverage factor of 14was average; factors of 20 or 30 were not uncommon. For example, if an investmentbank is able to borrow money for 6 per cent and expects a return of 8 per cent onlow-risk, prime RMBS and 16 per cent on high-risk subprime, it effectively makes,respectively, 2 per cent and 10 per cent. However, when returns are lower than theinterest rate for which they have borrowed money, for example, respectively, 4 per centand 2 per cent, the investment banks not only miss 4 per cent or 14 per cent calculatedprofit, they also have to take their losses on their equity. For example: 14 (the averageleverage factor) times, respectively, 2 per cent (6 per cent minus 4 per cent) and 4 percent (6 per cent minus 2 per cent) equals equity losses of, respectively, 28 per cent and56 per cent. Since the leverage factors in many cases were even much higher than 14,some financial institutions and investors that were heavily involved in RMBS, andespecially subprime RMBS, effectively went bankrupt.

Third, both professionals and academic economists do not pass up an opportunityto point out that many borrowers took out loans they could not afford. This is correct,but in most cases this was not because borrowers were eager to get a big loan eventhough they had bad credit. A majority of the subprime loans went to borrowers withprime credit (Brooks and Simon, 2007; Dymski, 2007). In other words, subprimelending should not be defined as lending to borrowers with poor credit, but as lendingat higher fees and interest rates whether or not borrowers actually have bad credit. In2006, 13 per cent of outstanding loans were subprime, but 60 per cent of the loans inforeclosure were subprime, up from 30 per cent in 2003 (Nassar, 2007). Sellingsubprime loans to prime borrowers was good business for both mortgage lenders andbrokers. Lenders could charge higher interest rates on subprime loans and thus makemore money. For this reason lenders gave brokers bigger sales fees for sellingsubprime loans. Brokers did not have negative results as a consequence of defaultingborrowers, as they only get paid for what they sell. And defaulting borrowers actually

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created a bigger market for refinancing, which implied that brokers could make moremoney on clients by selling them another loan.

Fourth, it is often argued that subprime lending enabled many people that wereformerly excluded from homeownership, i.e. low-income and ethnic minority groups, tobuy a house and enjoy the benefits of homeownership. This is questionable for at leasttwo reasons. Firstly, many of these borrowers had bought properties at the lower endof the market that needed improvement work and because of the high interest ratestheir monthly expenses often went out of scale with their income.

Homeownership for many subprime homebuyers became a burden rather than ajoy. Second, most subprime loans were not enabling home ownership as more than halfof them were refinance loans and second mortgages – in other words, loans for peoplewho already owned a mortgaged property. Most of the refinance loans were designedin such a way that they looked cheaper than the original loan, but would, in fact, turnout more expensive for the borrowers and more profitable for the mortgage broker andthe lender. Adjustable rate mortgages (ARMs) are a good example: an ARM may startwith a low interest rate, but after two or three years the interest rate resets to a muchhigher rate. Borrowers are shown the initial, low interest rate while the higher interestrate is hidden in the small print of an illegible mortgage contract. Predatory loans weresold mostly in neighbourhoods with ethnic minority populations. Almost half of theloans in minority areas were predatory, compared to 22 per cent in white areas (Averyet al., 2007). African-Americans receive more than twice as many high-priced loans asWhites, even after controlling for the risk level of the borrower (Schloemer et al., 2006).It then comes as no surprise that foreclosures are concentrated in certain parts of thecity. These problems are not new: for at least ten years researchers have pointed outhow subprime and predatory lending result in rising default and foreclosure rates (e.g.Pennington-Cross, 2002; Squires, 2004; Wyly et al., 2006). Yet, this was not considered amajor problem until house prices declined and the value of RMBS fell.

Rescuing Fannie Mae and Freddie Mac was needed to guarantee the continuation ofmortgage lending in the USA. Fannie and Freddie are so crucial to the entire systemthat without them the current mortgage market would fall apart. They are responsiblefor guaranteeing loans, for issuing “confirming” RMBS (i.e. low-risk, standardizedsecurities), and have also bought so-called “private label” RMBS (i.e. securities that arenot issued by Fannie and Freddie and include many subprime RMBS). Giving up onFannie and Freddie would have meant giving up on the American economy. But as weall know the intervention of the federal government goes much further than the bailoutof Fannie and Freddie. The Paulson plan of $700 billion is only part of a bigger effort tohelp the financial sector. Yet, very little of the money invested is designated to helpdefaulting homeowners from being foreclosed on. The American Housing Rescue andForeclosure Prevention Act of 2008 will probably help up to 500,000 homeowners. Thenumber of foreclosures for 2007-2009, however, will add up to seven to ten million. Inother words, government is bailing out financial institutions that made major mistakeswith billions of dollars, but does not even make enough funding available to stop theincrease in the millions of homeowners that are being foreclosed on. The priority of thestate is with exploiting financial institutions, not with exploited homeowners, eventhough a “foreclosure rescue plan” would have been much cheaper and could haveguaranteed the flow of money from homeowners to RMBS investors, albeit at a lowerrate of profit.

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References

Aalbers, M.B. (2008), “The financialization of home and the mortgage market crisis”, Competition& Change, Vol. 12 No. 2, pp. 148-66.

Avery, R.B., Brevoort, K.P. and Canner, G.B. (2007), “The 2006 HMDA data”, Federal ReserveBulletin, Vol. 93, pp. 73-109.

Brooks, R. and Simon, R. (2007), “Subprime debacle traps even very credit-worthy”, Wall StreetJournal, December 3, p. A1.

Dymski, G.A. (2007), “From financial exploitation to global banking instability: two overlookedroots of the subprime crisis”, working paper, University of California Center Sacramento,Sacramento, CA.

Gotham, K.F. (2006), “The secondary circuit of capital reconsidered: globalization and the US realestate sector”, American Journal of Sociology, Vol. 112, pp. 231-75.

Immergluck, D. (2009), Re-forming Mortgage Markets: Sound and Affordable Home Lending in aNew Era, Cornell University Press, Ithaca, NY.

Nassar, J. (2007), “Foreclosure, predatory mortgage and payday lending in America’s cities”,testimony before the US House Committee on Oversight and Government Reform,Washington, DC.

Pennington-Cross, A. (2002), “Subprime lending in the primary and secondary markets”, Journalof Housing Research, Vol. 13 No. 1, pp. 31-50.

Schloemer, E., Li, W., Ernst, K. and Keest, K. (2006), Losing Ground: Foreclosures in the SubprimeMarket and Their Cost to Homeowners, Center for Responsible Lending, Washington, DC.

Squires, G.D. (Ed.) (2004), Why the Poor Pay More. How to Stop Predatory Lending, Praeger,Westport, CT.

Wyly, E.K., Atia, M., Foxcroft, H., Hammel, D. and Philips-Watts, K. (2006), “American home:predatory mortgage capital and neighbourhood spaces of race and class exploitation in theUnited States”, Geografiska Annaler B, Vol. 88, pp. 105-32.

About the authorManuel B. Aalbers (PhD) is a researcher at the Amsterdam Institute for Metropolitan andInternational Development Studies (AMIDSt) at the University of Amsterdam, The Netherlands.He is the Associate Editor of the Encyclopedia of Urban Studies and Guest Editor of a SpecialIssue of the International Journal of Urban and Regional Research on mortgage markets. Hismain research interest is in the intersection of finance, the built environment and residents. Hehas published on redlining, social and financial exclusion, gentrification, the privatization ofsocial housing, financialization, and the Anglo-American hegemenony in academic research andwriting. Manuel B. Aalbers can be contacted at: [email protected]

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Regulation and subprime turmoilArvind K. Jain

Department of Finance, Concordia University, Montreal, Canada

Abstract

Purpose – The global economy has entered what appears to be a very serious financial crisis forreasons other than force majeure. While the current focus has to be on preventing a repeat of the GreatDepression, efforts must also be made to understand why the crisis came about in the first place. Theobjective of this paper is to demonstrate that the regulators should have known what the risks wereand that these risks were large and systemic, and should have concluded that actions were required toprevent a serious global crisis.

Design/methodology/approach – The article analyzes the developments in the US mortgagemarket to assess whether the chances of a crisis in the period before the crisis could have beenassessed to be too remote to warrant concern.

Findings – The evidence seems quite clear that, given the assessments of potential consequences ofprevious episodes in which concerted actions had to be taken to prevent the collapse of the globalfinancial system, the regulators of the US economy should have taken steps long before the onslaughtof chains of collapse of financial institutions that began in the summer of 2007.

Originality/value – It is hoped that analysis such as this will lead to improvement of regulations offinancial markets, reducing chances of future crises of such proportions.

Keywords Recession, Regulation, Financial markets, Derivative markets, Securities markets,United States of America


IntroductionAt the height of the current financial crisis, Christopher Cox, Chairman of the Securitiesand Exchange Commission issued a statement that began: “The last six months havemade it abundantly clear that voluntary regulation does not work”[1]. Four weekslater, Alan Greenspan admitted to the US Congress that “I made a mistake inpresuming that the self-interest of organizations, specifically banks and others, wassuch that they were best capable of protecting their own shareholders” (Beattie andPoliti, 2008). What is surprising about these statements is not that they were made bypeople who had played a leading role in pushing the idea of “self-regulation” but thatthey should have expected the self-regulation to work in the first place. While the usualsuspects for the crisis – greedy mortgage lenders, heartless and overpaid bankers,MBA culture, financial derivatives, loose monetary policy in the USA as well asconsumers in Asia who saved too much – have been rounded up, not many seem tohave the courage to point a finger at the real culprits. For some time before the crisisreached its apex in the fall of 2008, the US financial markets and the economy hadbeing drifting toward a precipice with poorly priced risks and unsustainable domesticand international balances. The regulators who should have recognized systemic andwidespread risks within the economy and should have taken steps to prevent anexplosion of these risks seemed to have been too greedy themselves. To be fair, theirgreed was not financial – they perhaps wanted to be seen as having presided over oneof the longest runs of unbroken assets growth.



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More than anything else, the subprime crisis is a story of hubris. It is a story ofhubris at the highest levels of the economy, where those with an ability to take actionchose to stay on the sidelines because of their belief that “the cost of slowdown today ismuch higher than the cost of a crisis in the future”. That has proven not to be the case.

The origin of the 2008 global financial crisis lies in the housing market. Mortgagesthat could not have been repaid except under the most optimistic of assumptions werebeing issued without any controls. Those who issued the mortgages passed on therisks to others – mostly quite sophisticated investors – in the form ofmortgage-backed securities without an independent assessment of risks by thebuyers. These investors were responsible for their actions. Under normalcircumstances, self-regulation should have worked. Buyers of these mortgageswould suffer losses when the mortgages defaulted and the market system would havedone its job. Unfortunately, in this case, there were two problems. First, some of theseinvestors were financial institutions. Their individual losses create systemic risks forother participants in the financial markets. Second, the potential size of the defaultswas becoming so large that the investors could not have been expected to pay fully forthe losses. Their entire equity capital would have been less than the size of losses in themortgage market under states of nature that would have been considered highlyprobable. They would leave a significant share of the losses for others to pick up. Thisis where regulators are supposed to come in – to prevent behavior that has negativeexternalities that create systemic risks. This is specially true when the externalities arelarge and when we have sufficient past experience that tells us that such eventualitiesare not merely figments of the imagination of those who stick to their beliefs in thesuperiority of socialist regimes.

This paper traces the developments that led to the financial crisis and thenevaluates the validity of charges against the “usual culprits”, The objective of thispaper is to demonstrate that the regulators should have known what the risks were andthat these risks were large and systemic, and should have concluded that actions wererequired to prevent a serious global crisis. Their hubris is the main cause of the crisis,which could have been avoided.

Regulation of financial marketsAn appropriate level of regulation is key to the functioning of a market system.Regulation is needed to fulfill an essential requirement for the market system to work:establishment of property rights and prevention of fraud. It is now common knowledgethat economic systems that protect entrepreneurs as well as minority shareholders andcreditors reach higher levels of development than those that fail to provide protectionfor all property holders. Such protection requires balancing too little regulation againsttoo much of it. Too little regulation discourages entrepreneurs (they do not reap theirdue rewards under corrupt systems) and too much regulation acts as barriers toinvestments. Too little regulation exposes small investors to expropriation of theirwealth by managers and majority shareholders, and too much regulation discouragesthem from investing in the productive assets of the economy.

Balanced regulation is even more important for the financial sector of the economy.Financial institutions in a modern economy are far more intertwined with each otherand with investors than non-financial firms. Given the ease and speed ofcommunication as well as the choice of financial instruments available, financial

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firms are able to fine-tune sources and uses of their funds to an extent that a smalldisruption in their plans can create ripples throughout the financial system. Activitiesof each financial institution entangle hundreds of other institutions and one baddecision will require settlements between many institutions across legal and nationalboundaries. When Long Term Capital Management (LTCM) faced bankruptcy inSeptember 1998 arising from its bad investment decisions, Federal Reserve officialsintervened to develop a private sector rescue package not out of their concern forLTCM investors but because of their concern for potential consequences of the failureof LTCM on the financial markets (Dowd, 1999). Financial sector regulation is neededbecause activities of individual institutions can create negative externalities that giverise to systemic risks. Individual institutions may have to bear a major share of theconsequences of their poor decisions, but poor investments in financial markets riskbringing down innocent bystanders. Central banks offer deposit insurance becausebanks cannot handle the consequences of too many depositors acting in the samefashion – howsoever rational from their own perspectives – in view of bad news.Financial regulators impose capital adequacy requirements to ensure that lossesarising from poor decisions will be borne fully by the banks that make bad decisions.

Self-regulation, whether of financial markets or ordinary human behavior, does notwork when risks and rewards associated with one’s behavior are distributedasymmetrically. Regulations becomes necessary when those who benefit from riskybehavior either do not bear the full costs of that risky behavior or have a subjectivediscount rate for the distant costs that is higher than that of the society which may haveto bear those costs. This is why societies discourage smoking. We regulate speeding onhighways because benefits are instantaneous; costs are underestimated due to “disastermyopia”. In financial markets, educated investors who make their own investmentchoices do not need regulation because they bear the consequences of their decisions –good or bad as long as they have adequate capital. Regulations becomes necessary onlyif some of the consequences of bad decisions are externalized to third parties and lead tothe creation of systemic risks for the financial markets and other participants.

The subprime crisis is an outgrowth of asymmetric distribution of risks andrewards. It is not clear why voluntary regulation was expected to work in thissituation. Those who benefited from issuing poor quality mortgages – the originatorsof the mortgages – were not expected to lose if the borrowers defaulted. They hadcompletely externalized the consequences of their decisions by selling these mortgageswithout recourse. They would have paid the price for issuing risky mortgages if thoserisks had been incorporated in prices of mortgage-backed securities. For reasons stillnot understood, rating agencies were classifying these securities as high quality papereven when they contained large shares of sub-prime mortgages[2]. There was no needfor self-regulation on the part of mortgage issuers. In fact, self-regulation would havebeen irrational. The risk of these mortgages was being transferred to investors whoseemed oblivious to the risks associated with the mortgages. The risk, however, hadnot disappeared. Regulators had to understand that buyers were taking on risks thatthey did not understand, assess possible consequences, including systemic risks underunfavorable states of nature, and take steps to protect the system.

Regulators deluded themselves that markets were efficient in pricing risk evenwhen given a free lunch. The economists’ joke that “there cannot be a dollar bill lyingon the road because someone would have picked it up” works only on the lecture

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circuit. Regulators suffered from the investors’ curse of “overconfidence in theirabilities” and ignored everything that the past crises have taught us about howindividuals and markets behave. The subprime crisis of 2007-2008 is not a crisis ofgreed or excessive financial innovations, it is a crisis of hubris.

Rise and fall of NINJAsThe origin of the present crisis lies in the deterioration of the lending standards for housemortgages in the USA. Market innovations and deregulation have changed the nature ofthis market dramatically over the past two decades. In the past, commercial banks usedto issue mortgages and if the mortgage met the strict credit requirement of organizationslike Fannie Mae they could sell the mortgage to these government-sponsored enterprises(GSEs) and receive funds to issue more mortgages. This process increased the pool offunds available for issuing mortgages to homeowners. The key was the quality of themortgages. Two changes in this market lead to the growth of subprime mortgages. First,investors began to invest in mortgaged-backed securities issued by thegovernment-sponsored enterprises like Fannie Mae and Freddie Mac. Second, banksthemselves began to package the mortgages into collateralized debt obligations (CDOs)and sell them directly to investors.

Two other developments coincided with the arrival of new investors and the issuersof mortgages. First, the trend in the house price appreciation accelerated towards theend of 1990s. Second, low interest rates following the short recession in 2002 had madeinvestors search for high returns even if it meant higher risks. With rising house pricesand investors’ appetite for risk, the stage was set for the rise of what became known assubprime mortgages. Rising house prices made it attractive to invest in houses, andbanks that had entered the mortgage financing business began lending to borrowerswho would normally not be considered credit-worthy. The quality of mortgages wentdown, banks created captive institutions called structured investment vehicles (SIV),and began to issue ever-increasing amounts of mortgage-backed securities. Once whathad now become a high-risk mortgage lending business had been moved off thebalance sheets through SIVs, banks were content to let mortgages be issued, combinedto form CDOs and be sold to investors in three tranches depending upon their risks:

(1) prime (very low risk tranche);

(2) Alt-A; and

(3) subprime (the highest risk tranche).

The subprime mortgages were often given to borrowers who had no means to repaythe mortgages – the premise was that appreciation of house prices would provide thelenders sufficient cushion to recover their investments[3].

Figure 1 shows the movement of house prices in the USA as measured by theCase-Shiller home price index for ten or 20 urban areas. The 20-city index more thandoubled between early 2000 and July 2006 – when it reached its peak. Figure 2 showsthe growth of the mortgage market. Prime mortgages, which had accounted for almost90 percent of the market in 2003, constituted less than 60 percent of the market in 2006.The mortgage market, which itself is a very large part of the financial markets, was by2006 dominated by subprime and Alt-A mortgages. At least the subprime part of thesemortgages was unserviceable except under the most favorable conditions and wouldcause mortgage holders to lose money unless house prices continued to appreciate.


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This is indeed what began to happen more frequently in 2006. Figure 3 compares thesubprime mortgages that were in delinquencies since their origination in various years.The vintage year was 2003. Mortgage delinquencies were at their lowest for the firstdecade of the new century (delinquency rates for the missing years of 2000-2002 are

Figure 1.House price movements inthe USA

Figure 2.Mortgage market in theUSA

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between the rates for 2003 and 2005). Delinquency rates rose consistently from 2004 to2007. By the fall of 2008, 37 percent of mortgages issued in 2006 with a life of 27months were delinquent. More than 20 percent of mortgages issued in 2007 weredelinquent within 15 months.

The delinquency rates could not be blamed completely on the state of the economy.The prime mortgages, although following somewhat similar patterns as the subprimemortgages, had maintained their delinquency rates to mostly under 2 percent. Table Icompares selected delinquency rates for the three sectors of the mortgage market.

Mortgages account for about one-quarter of the fixed income market in the USA. By2006, the subprime and Alt-A segment accounted for about $914 billion, or 41 percentof the mortgage market. By the end of that year it was also clear that house prices weretaking at least a temporary breather (Figure 1). It would be rational to assume that ifthe appreciation of house prices did not resume, default rates on a market segment that

Original balance in delinquency (%)Year of issue Months since origination Prime Alt-A Subprime

2003 60 0.4 1.7 152005 12 0.1 1.0 6.12005 30 0.9 7.8 292006 27 2.1 16 372007 12 1.1 7.9 17

Source: IMF (2008, data for Figure 1.8)

Table I.Selected delinquency

rates

Figure 3.Delinquency rates ofsubprime mortgages


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accounted for about one-tenth of the fixed income market of the entire economy wouldrise even further.

Why were the buyers of these mortgage-backed securities not concerned about therisks? This remains a mystery. Formally, these securities were being rated by creditagencies and were given very high credit ratings. That, however, does not absolveinstitutional investors – manager of funds and of banks that were acquiring thesesecurities – from the responsibility of assessing the risks themselves. No one has yetoffered an explanation for why the rating agencies were providing the ratings that theydid, or why the buyers themselves were willing to trust the rating agencies socompletely.

The situation during the period from the middle of 2006 to the middle of 2007 can besummarized as follows. A very significant portion of markets’ funds were being lent tosubprime borrowers. The most derogatory term to describe these loans has been “ninjaloans” – “no income, job or assets”. The only justification for lending was theexpectation that house prices would continue to appreciate and the lenders wouldrecover their funds from the appreciation of the prices when borrowers default. Theborrowers really did not matter in these loans. The loans made sense under theassumption of continuous increase in house prices. The risks of these loans were notbeing borne by the issuers of the loans, but were fully transferred to independent andunrelated investors in the financial markets. There was considerable evidence,including Alan Greenspan’s own statement that the investors were not fully aware ofthe risks they were taking. A significant proportion of these loans was held by banks.By 2006, or at least by 2007, it was clear that house prices were not going to continue torise. Default rates on these mortgages had begun to rise. Should the default ratesexceed certain critical levels, banks would suffer large losses. Could those losses havebeen estimated to be large enough to create systemic risks for the country’s orinternational financial system? The answer to this was provided by the failure ofseveral hedge funds owned by banks in the middle of 2007.

Greedy bankers and derivativesThe three most common explanations for the subprime crisis seem to be the greedybankers who paid themselves high salaries and bonuses with scant regard for theinterests of the shareholders, innovations in the area of financial derivatives whichallowed risks to be taken without full understanding of what was involved, and lowinterest rates after the 2002 recession which changed the risk-appetite of investors.While there may be a kernel of truth in the assertion that these factors made a badsituation worse, it is hardly justified to shoot the messenger for being the bearer of thebad news.

Bankers did not become greedy in 2003; they have always been greedy. Whatchanged about the greed of bankers that surprised us and caught us unprepared?Greed is the driving principle of a market economy. Where is the surprise in this?

Financial derivatives have been around for decades. There have been numerouscrises involving individual financial institution and rogue traders or managers thatexposed the vulnerabilities of institutions (and the system, as in the case of LTCM) touncontrolled or unsupervised use of these instruments. The use of now infamous creditdefault swaps by financial institutions to protect themselves from risks ofmortgage-backed CDOs, risks that they did not understand, was merely a sideshow

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to the subprime mortgages that were being given out. The crisis did not originate inthese swaps – it originated in bad loans. The existence of swaps has made thesituation difficult to untangle – something that had to be taken into account when theassets that were giving rise to the risks were being left unsupervised. The existence ofthese swaps and other derivatives is precisely the reason the regulatory authoritieshave to assess the systemic risks that arise from what may appear to be isolated losses.In a simple financial system, a mortgage-issuing financial institution would suffer lossof a bad mortgage, and provided it has sufficient capital, no one would be any wiser. Ina modern and very complex financial system as ours, the mortgage-issuing financialinstitution take steps to protect itself against the potential loss from that mortgage, andthus involves a host of other financial institutions in the risks associated withindividual assets on its balance sheet. These are the externalities and the systemicrisks that the regulators have to take into account.

Finally, did the low interest rates lead to the crisis? Only in so far as the low interestrate made the mortgage rates look very attractive! Low interest rates were therequirements of the economy at that time. Low interest rates on safe deposits are not ajustification for buying high-return assets without assessing the risks associated withthose returns and without ensuring that risks are being properly priced.

The usual culprits are the easy targets.

Concluding remarksWere the regulators of the economy, starting from the Federal Reserve and includingthe Office of the Controller of the Currency, Securities and Exchange Commission,Federal Deposit Insurance Corporation, Commodity Futures Trading Commission andFederal Housing Finance Agency, along with various state level banking regulators,sleeping at the wheel as the US economy was heading for a disaster and threatening todrag the rest of world with it? Behavioral economists now have very descriptive termsto explain actions of investors that challenge the traditional assumption of rationalityon the part of economic agents. Two that come to mind in this crisis are “investoroverconfidence” and “disaster myopia”. Investors – and in the case the regulators whobelieved in the omnipotence of markets – seem to think that their assumptions aboutthe future do not have to conform to reality. House prices can go on rising forever.They know what the market does not – and hence normal economic rules do not applyto them. Investors and regulators also tend to believe that if a disaster has nothappened for a while, it may never happen again. One’s subjective probability of anundesirable event falls below its objective probability as the most recent occurrence ofthat event recedes into the past. Never mind that banks had lent up to 70 percent oftheir capital to individual emerging countries just 20 years back under the assumptionthat “countries do not go bankrupt” and then spent a decade restoring their balancesheets when the countries did go bankrupt – that was the old system. Never mind theS&L crisis in the USA – we had solved that problem.

From the time the subprime mortgages were being issued, it was clear that the onlyjustification for these loans was the assumption that house prices would continue torise at their recent rates well into the future. These loans were becoming a verysignificant part of the US financial market by 2005. The impact of defaults would notbe confined to individual investors. There would be systemic consequences. The risksof these loans were not being borne by those who benefited from the issuance of these


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mortgages. A flaw in the system – unchecked rating agencies – allowed sophisticatedinvestors to fool themselves into underestimating the risks of their investments. It isnot clear how the regulators could put these developments together and still believethat self-regulation is all that was needed. Mortgages issuers could not care aboutsystemic risks, investors believed that they would get out of the markets if thingsbegan to look bad, and regulators were too afraid to take the punch-bowl away whenthe party was in full swing.

Behavioral scientists need to come up with a term for drivers sleeping at the wheel.

Notes

1. “Chairman Cox Announces End of Consolidated Supervised Entities Program”, available at:www.sec.gov/news/press/2008/2008-230.htm (accessed 26 September 2008).

2. In what may be the greatest irony concerning this crisis, some managers of leading hedgefunds, whose raison d’etre is understanding risk and arbitraging minor imperfections in riskassessments by the market, blamed the “financial system” and accused rating agencies ofhaving “facilitated the sale of ‘sows’ ears [. . .] as silk purses’ through ‘fanciful’ ratings ofmortgage-backed securities’, completely setting aside their responsibility for assessment ofrisks associated with assets they were acquiring (Kirchgaessner and Sender, 2008).

3. Academic research demonstrates that these loans were being pushed. Dell’Ariccia et al.(2008) find that increase in number of mortgages (a sign of pushing) is directly related to therate of defaults.

References

Beattie, A. and Politi, J. (2008), “I made a mistake, admits Greenspan”, Financial Times, October24, p. 1.

Dell’Ariccia, G., Igar, D. and Laeven, L. (2008), “Credit booms and lending standards: evidencefrom the subprime mortgage market”, CEPR Discussion Paper No. 6683, Centre forEconomic Policy Research, London.

Dowd, K. (1999), “Too big to fail: long-term capital management and the Federal Reserve”,Briefing Report No. 52, September, Cato Institute, Washington, DC.

IMF (2008), Financial Stability Report, October, Geneva.

Kirchgaessner, S. and Sender, H. (2008), “Hedge fund chiefs blame the system for financial crisis”,Financial Times, November 14, p. 19.

About the authorArvind K. Jain is Associate Professor in the Department of Finance, Concordia University,Montreal, Canada. His current research focuses on corruption and poverty. His papers oncorruption, debt crisis, capital flight, international lending decisions of banks, commodity futuresmarkets and other topics have appeared in Journal of International Business Studies, Journal ofMoney, Credit and Banking, Economics Letters, Journal of Economic Psychology, Journal ofEconomic Surveys, and other academic journals. He has written two books, Commodity FuturesMarkets and the Law of One Price (1981) and International Financial Markets and Institutions(1994), and has edited two volumes: Economics of Corruption (1998) and The Political Economy ofCorruption (2001). Arvind K. Jain can be contacted at: [email protected] [email protected]

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An economic wonderland:derivative castles built on sand

Jon ClokeGlobal and World Cities Group, Geography Department,

Loughborough University, Loughborough, UK

Abstract

Purpose – This paper seeks to use the way in which markets in derivatives have developedhistorically to examine how neo-classical market-oriented economic theory has been used as astalking-horse to create an illusionary market in the increasingly complex derivatives that havebrought about the current global financial crisis and which threaten liberal democracy.

Design/methodology/approach – The paper analyses the current global financial crisis usingthree separate themes in the development of derivatives themselves: the development of financialderivatives themselves; the subversion of risk analysis; and the co-opting of the concept and analysisof fair value by the financial services industry and its support network. These themes are used to showhow self-regulation, supervision and the perception of risk have effectively been abandoned in thecreation of an immensely profitable market based on an imaginary product. The study uses acombination of available facts and figures from professional literature and from international financialinstitutions and financial services organisations, as well as comparative analyses outlining financialservices praxis.

Findings – It is suggested that in an effectively unregulated, globalising capitalism this crisis andothers like it are inevitable, and that the self-regulating capacities of capitalism suggested byneo-classical theory are non-existent.

Originality/value – The paper uses facts and figures provided by the financial services industry toillustrate the poverty of the theoretical justification of the market in financial derivatives and thecritiques of various practitioners and experts to point out that the crisis came foretold.

Keywords Derivative markets, Recession, Financial markets


Virtually every aspect of conventional economic theory is intellectually unsound; virtuallyevery economic policy recommendation is just as likely to do harm as it is to lead to thegeneral good. Far from holding the intellectual high ground, economics rests on foundationsof quicksand. If economics were truly a science, then the dominant school of thought ineconomics would long ago have disappeared from view (Keen, 2001, p. 4).

In the full flood of the current credit/financial crisis there appears to be no shortage ofpeople and organisations to blame – short-sellers in the market, profligatehome-owners in the USA who signed up for mortgages that they could not afford,Fannie Mae, Freddy Mac, the executives of investment banks and their million-dollarbonuses, hedge funds, the Fed, etc. Whilst the desire to find a culpable victim isperfectly understandable, it is also obvious that there is no “silver bullet” causalmechanism for this rapidly developing systemic failure. It is the purpose of this articleto look at socio-political and cultural determinants of the current crisis, and to do sousing three intertwined themes:



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DOI 10.1108/17422040910938730

(1) the development of financial derivatives themselves;

(2) the subversion of risk analysis by globalising capitalism; and

(3) the co-opting of the concept and analysis of fair value by the big accountancyfirms and banks, through which financial derivatives were valued.

In doing so it is not the intention of the article to imply that these three themes bythemselves are the main villains of the piece, if not to suggest that they clearlydemonstrate a particular type of cultural and institutional systemic change which hastaken place over the last three decades of the development of the supremacist ideologyof globalising capitalism. It will be the suggestion of this article that the developmentof an enculturated, fundamentalist, market-orientated economic discourse since the1970s has acted as a stalking-horse for the development of new, powerful, unrestrictedand unregulated markets in the financial services sector, a stalking-horse which is byits very character anti-democratic. Thus far nothing particularly new – except that,with the development of financial derivatives and CDOs, such is the power of thissupremacist ideology that a massive global market has developed in products whichare essentially imaginary.

Democracy underpinned by law or constitutional framework, liberal democracies ofWestern Europe or the constitutional democracy of the USA, work on the basis of therefreshing and realistic central precept of the inevitability of human fallibility – allpower corrupts and democracy is the politics-made-flesh of that acceptance. There canbe no end-state to democracy, it is and will always be a process undergoing continualfracture, revision and change. To paraphrase the quote about art often attributed toMussorgsky, any given form of democracy is not an end in itself, but a means ofaddressing humanity; it is a process whose development is essentially characterised byendless subversion, thwarted and side-stepped by constant attempts from within andwithout to turn its frail authority into personalised or oligopolistic power to be usedagainst it.

Democracy by its very nature, therefore, both hosts and is vulnerable to a limitlessrange of counter-narratives, ranging from tiny political movements to globalmeta-narratives which, in being given freedom to thrive, may at any time metastasiseinto the illness that kills the host. Ideological fundamentalists of whatever kind(Christian, Islamic, nationalist/populist or left/populist, for instance) whose corediscourses may allow them to use democratic mechanisms to achieve power within agiven democratic type, may then use those same mechanisms to restrict or even closedown democratic practices as being inimitable with contradictory core beliefs.

Not all core discourses have arisen under democracies, of course, and many of thempredate the earliest democratic ideas by thousands of years, but Westernliberal/constitutional democracies are presently threatened by one of the youngest.The Trojan horse of theoretical market fundamentalism that has been made flesh sincethe 1970s has carried within it what this article will refer to as a market fantasistdiscourse, the presumption over and above the theoretical dominance of market forcesthat a market exists simply because we will it to be so and that its workings will beself-correcting and tend towards healthy equilibria, under no matter whatcircumstances.

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The theoretical dictates of market fundamentalism have long been more dangerousthan any other core discourse for different reasons. Amongst the most important ofthese are because it has become the doxa of governmental structures and actors acrossthe North/West and because it has as a core belief a direct contradiction to the centralprecept of democracy discussed above – the idea that the unheeding self-interest ofbillions (in reality, of course, no more than a few thousand elite worldwide) actingtogether will lead to a universally prosperous and orderly society. It is in other wordsan essentially virtuous reading of psychosocial, sociological and anthropologicaltendencies[1]. In this late-twentieth and early twenty-first century mutation of theClassical economic school of the late nineteenth century, self-interest and conflict ofinterest have been inverted into virtues and internalised as good for the health of thebody politic – human fallibility and the tendency towards corruption become in thisreading essential motors for a prosperous society.

It might seem a long step from an extemporaneous discussion of democracy andmarkets towards the present credit crunch (plus housing market collapse, plus bankingcollapse) and yet the connecting thread is firm and direct. Market fundamentalismcontains a further anti-democratic core belief, which is its claim to scientific status andfrom that an objective, nomothetic capacity; to quote the then-Chief Economist to theWorld Bank, Larry Summers, at an IMF summit in Bangkok in 1991: “The laws ofeconomics, it’s often forgotten, are like the laws of engineering. There’s only one set oflaws, and they work everywhere”. There is no alternative under this reading of thelaws of economics, and market fantasy has become one symptom of this delusionaryillness that the body democratic has become host to.

The current theological mutation of market fundamentalism is not alone in this,however; there are (for instance) significant numbers of Muslims, Jews and Christianswho believe that their core religious beliefs are quite literally true and the only validexplanation for the world in which we live; these core essentialists from each religionwould advance the argument that since they are the unique possessors of anincontrovertible truth, ideally all countries and all people should live under the rulesespoused by that core discourse. It might be argued, however, that since the turf fightsbetween Islamic and Christian belief systems from the seventh century onwards, fewcore discourses have come as close to being accepted on a global basis as marketfundamentalism has after the collapse of the Socialist Bloc in 1989. Marketfundamentalism comes close to being the first uber-modernist religion to confrontpost-modernism and post-structuralism; a core belief system that is still just a beliefsystem, but which has overcome the traditional limitations of religion (and indeed ofdoubt) by asserting the coloration of scientific inevitability and primordial immanence– from which springs the market fantasist mindset.

Necrotising marketitis

Monetary forces, particularly if unleashed in a destabilizing direction, can be extremelypowerful. The best thing that central bankers can do for the world is to avoid such crises byproviding the economy with, in Milton Friedman’s words, a “stable monetary background” –for example as reflected in low and stable inflation [. . .] I would like to say to Milton andAnna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanksto you, we won’t do it again (Bernanke, 2002).


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Whilst the Socialist Bloc existed, the governments of liberal Western democracies hadof necessity to be politically restrained in their approach to market freedom; the threatof an alternative discourse-in-practice existed (however imperfect) and thegovernments of the Western Bloc had to exert caution over permissible amounts ofwhat is now euphemistically termed “volatility” (whereas the central concern was ofcourse the mass unemployment such volatility might incur and the resultingsocial/civil unrest that might accompany it, a more direct challenge to the system).Financial derivatives began a new era, however, with the deregulation of foreigncurrency exchanges in the 1970s and the introduction of standardised options in 1973.

By the 1980s, at the same time that it no longer seemed in any way probable thatWestern liberal democracy would succumb to the global advance of Soviet Socialism(irrespective of the final throe that the Soviet invasion of Afghanistan in 1978 was tobecome), an increasing confidence in the supremacy of globalising capitalismoverthrew any perceived need for regulatory caution, especially during and after thetriumphalist, monetarist regimes of Margaret Thatcher in the UK and Ronald Reaganin the USA. The terminal decline of the Socialist Bloc that culminated in the iconicevent that was the fall of the Berlin Wall came accompanied in globalising capitalismby an increasing boldness in the development of market instruments. Two of the moreimportant amongst these, the packaging of US mortgage bonds from the 1980sonwards to create collateralised debt obligations and the selling of default protection ascredit default swaps from the 1990s (after the fall of the USSR) became two key actorsin the current crisis.

Accompanied by massive and sustained pressure towards the deregulation of allmarkets and stock exchanges in particular, what had been originally created asrelatively crude instruments for hedging loan exposure developed rapidly into far moresophisticated instruments as the voracious demand for capital that fuelled thenon-inflationary continuous expansion (NICE) era of the 1990s increased apace. By theturn of the century credit derivatives had multiplied so rapidly in type and extent andcapital capture that they constituted a market of themselves, and the fall of Enron andwhat that had to say about the risk associated with credit derivatives was effectivelydismissed by markets, institutions, academics and professionals alike. As an editorialpiece in Risk magazine implied, shortly after the fall of Enron:

Credit derivatives proved to be resilient [. . .]. The episode, and the fact that the exercise of theEnron credit default swap contracts was done in an orderly manner without controversy,showed that the market had come of age.

Derivatives had been weighed in the balance and not found wanting[2]; added to whichof course the amounts of capital now invested in them plus the maturity of what hadbecome a market of central importance meant that, barring a disaster like the currentone, they could not be allowed to be perceived as having failed, or as having anessential flaw.

This perceived “coming of age” of the market was accompanied by an accelerationof the amount of money invested in this market, as Figure 1 shows.

As we now know, whereas banks in particular were important participants in thismarket from the beginning, hedge funds became increasingly involved as they toobecame important players in global capital markets.

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It is tempting but perhaps unhelpful to see financial derivatives as somehowsynonymous with the buzzword that became “globalisation” – exotic, powerful andbarely understood even by the most unquestioning fans. What is clear, however, is thatso representative had they become as part of the market fantasist discourse that theywere accepted almost universally (with a few notable exceptions such as George Sorosand Warren Buffett) as what they have become fatal to – the securitisation of risk.Derivatives were institutionally accepted as a marker of good health to the extent that(with exceptional irony) by 2004 the credit default swap (CDS) market was becomingincreasingly accepted as an accurate measure of credit quality, for instance in a specialanalysis produced by the Bank for International Settlements (BIS) in its QuarterlyReview of June 2004.

What had also become clear, however, was that no one state had the capacity tounderstand, much less supervise, the CDS market, whether it be through the moreformal regulatory approach of the USA or the “light hand”, self-regulatory approach ofthe UK – proprietors, respectively, of the most important financial centres in the world,i.e. the New York and London stock exchanges. In the market fantasist view, however,not only was this not seen as a disadvantage but, given the apparently “perfect”functioning of derivative markets this was one more proof of the superiority of marketover state and, by extension and with reference to the initial premises of this paper,over state-channelled democratic oversight – the markets were themselves becomedemocracy in action.

At the same time (and again, with almost overwhelming irony) that theinternational financial institutions (World Bank, IMF etc.) were demanding moretransparency, openness and accountability from the governments of countries indevelopment, the globalising financial services sector was lauding the development ofmarkets of increasing obscurity and impenetrability, over which regulation andoversight were all but impossible. The full scale and surreal nature of this market andits critical importance become apparent only when one looks at the BIS estimates for

Figure 1.Growth in credit

derivatives


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total monitored trade in derivatives – some $680,290,700,000,000 for 2007-2008 (Haas,2008). When this is compared with CIA estimates for the total world capital base($53,510,000,000,000) it is theoretically possible that a loss of just 7.87 per cent of totalderivatives exposure could wipe out the world’s capital base (Haas, 2008).

Such is the continuing faith in the market fundamentalist discourse, however, thateven with this critical leverage, in all of the current talk of “bail-outs” and “rescuepackages” the concentration of governments around the world has beenoverwhelmingly on easing the short-term liquidity crisis, which is to say examiningthe symptoms of the illness whilst doing little to examine the long-term andfundamental causes. It might (for instance) be thought that the massive stateintervention which the crisis has occasioned, the nationalisation of banks and the loansof taxpayers’ money to failing institutions should be accompanied by task forces notonly to investigate the exposure of each and every recipient of public money to the“toxic” instruments, but in working out how to defuse the global market in derivatives,how to regulate such instruments effectively and how to licence very strictly theirfuture development. Despite lip-service being paid to regulation of these kinds, theemphasis is strongly on bail-outs and interest rate cuts – “recapitalisation” is the orderof the day. The bankruptcy of this particular way of thinking, however, is obvious inphenomena such as the gap between the LIBOR inter-bank lending rate and centralbank interest rates – banks know very well what they’ve been up to and they also nowknow that they can’t trust the value of their assets.

They f * * * you up your markets do, but they were built to, just by you . . .

So combine an opaque and unregulated global financial system where moderate levels ofleverage by individual investors pile up into leverage ratios of 100 plus; and add to this toxicmix investments in the most uncertain, obscure, misrated, mispriced, complex, esoteric creditderivatives (CDOs of CDOs of CDOs and the entire other alphabet of credit instruments) thatno investor can properly price; then you have created a financial monster that eventuallyleads to uncertainty, panic, market seizure, liquidity crunch, credit crunch, systemic risk andeconomic hard landing (Roubini, 2007).

Market fundamentalism as an ideology purports to be nothing if not a moral analysisof human activity, and as a consequence of the necessity to justify the functioning ofcapitalism, a variety of ethical arguments are attached to both markets and capitalism:

Capitalism is the only system that fully allows and encourages the virtues necessary forhuman life. It is the only system that safeguards the freedom of the independent mind andrecognizes the sanctity of the individual (Tracinski, 2002).

In the literature, the signalling of virtuous market functioning is transmitted by pricestructures decided on through the use of relevant information and the analysis of risk,with the concomitant effect that this has on changes in market prices over time. Theprecept of risk is another fundamental pillar in the moral basis of marketfundamentalism, the idea that an entrepreneur undertakes to risk capital throughanalysing the market for a product, setting the price through use of availableinformation on both market and product, and accepting the risk of losing capital thatfailure to get your calculations right may bring – it is not an exaggeration to say that

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the premise of virtuous risk by the entrepreneur justifies by itself the profit-makingunderlying capitalism in this reading.

However, the entire purpose of many derivatives (and the CDS in particular) hasbeen to separate risk from product. Risk analysis, the commodification of and the tradein risk are specifically designed to factor out this virtuous uncertainty that justifiesprofit:

They mass manufacture moral hazard. They remove the only immutable incentive to succeed– market discipline and business failure. They undermine the very fundaments of capitalism:prices as signals, transmission channels, risk and reward, opportunity cost (Vaknin, 2005).

In this reading (and again referring to the ethical performativity of marketfundamentalism) there is something called moral hazard, which must be avoided. Thedevelopment of financial derivatives throughout the period since the 1970s (even theorigins and growth of hedge funds themselves) which have evolved to reduce risks tothe minimum, the continued failure and bail-out of national and regional bankingsystems (Mexico, Brazil, Asia, Turkey) plus unpunished failures (Russia (severaltimes), Argentina, China, Nigeria, Thailand) notwithstanding (existential empiricalevidence itself being non-existent) market fantasist belief in moral hazard mustcontinue – because it acts as an essential theological support for marketfundamentalism and its corollary, market discipline. For market fantasists and thosetending towards the left/social democratic section of the political spectrum alike, thesight of US, European and UK governments effectively nationalising major actors intheir banking sector during the ongoing credit crisis heralds nothing less than the “endof capitalism”, which some conservative commentators were predicting as long ago asSeptember 2007 when the UK government took a share in the Northern Rock BuildingSociety[3].

More fundamental perhaps is the way in which financial derivatives have developedsince the 1970s, not merely as a counter to the risk-based functioning of capitalism andthemselves weapons of mass moral hazard, but in virtual defiance of all precepts ofrisk analysis, if by risk analysis we understand a process that uses the systematicanalysis of available information in identifying hazards. Using obscurantist equationsto detach the element of risk on bundles of subprime mortgages so that they can berepackaged as products with an excellent credit rating, after all, is effectively reversingthat process – taking a known product with a probabilistically high risk quotient andthen obscuring that which is known about it.

CDOs using subprime packages, after all, have the effect of making it impossible todetermine the probability and frequency of mortgage default by mortgagee and thepossessing bank alike, making it impossible to determine the severity of the likelyconsequences of that risk and thereby neutralising the two main determinants of whichrisk itself is a function. In an inversion of the separation of risk and uncertaintyintroduced by Frank Knight’s (1921) seminal pioneering work on risk analysis, Risk,Uncertainty and Profit, CDOs internalise uncertainty as something highly profitable –a process which could only work (with the benefit of hindsight) under special,‘irrationally exuberant’ market conditions such as those underwritten by the housingand consumer bubble of the mid-1990s onwards.


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Quis custodiet ipsos custodes?

There are ominous long-term implications in the accountants’ slide to marginalization.Balance sheets loaded with toxic assets that are “marked-to-whatever” will suffer forcredibility under the noses of skeptical investors, who know full well that the pile of manureis still fermenting somewhere (Peterson, 2008).

Concealed by the fantasy-based performativity of espoused market-fundamentalistbeliefs discussed above there is another interesting and powerful socio-political themeof existential globalization. This is the effective development over the last threedecades of a supra-politics of hyper-accountancy, by which is meant the massiveincrease in growth and concentration of power in the accountancy sector (Boyd, 2004)and the extension of the involvement of the big four accountancy firms(PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young and KPMG) inevery area of nation-state activity, as well as those of international and multi-nationalquasi-governmental institutions. The concentration of oligopoly in the big four firms ofthe accountancy sector has given those firms shadow-state powers in vital areas of thebusiness of the nation-state, by (for instance and with particular reference to thesanctification of conflict of interest (COI) mentioned at the beginning of the article)becoming at the same time national and international advisors on privatisation of statefunctions, prime engines for the carrying-out of that privatisation and then auditors ofthe effectiveness of that privatisation (UNISON, 2002) – in the UK and the USA, inaddition, there has been a substantial ‘revolving door” for important political andgovernmental actors between employment and executive/non-executive positionswithin the big accountancy firms and employment in public office orgovernment-contracted consultancies.

Historically, the series of mergers that increased the power of the big accountancyfirms in the last two decades of the twentieth century came accompanied by twofurther phenomena that at once increased the probability of COIs whilst at the sametime pushing the firms to ignore them, in the search for audit clients and profits: thesetwo phenomena were, firstly, that audit clients became increasingly sophisticatedpurchasers of accountancy services (Boyd, 2004) and thus shopped around more for thebest deal; and secondly, because of the inherent flexibility in the interpretation ofaccounting standards, audit clients increasingly looked for accounting firms thatwould give interpretations as close as possible to those desired by the board, so-called“opinion shopping” (Magill and Previts, 1991, p. 124, cited in Boyd, 2004), so that thefinancial statements of the firm resembled as closely as possible the picture of the firmthat the board wished to present. Both of these two factors increased pressures to lowerprices and diminish profit margins and thus increased the tendency towards mergers,to take advantage of the economies of scale that such mergers might bring. At the sametime, the increasingly unhealthy nature of the auditor/client relationship was furtherexacerbated by the increase in numbers of accountants leaving their previous employerand taking up posts in the firms that they had previously been auditing, of which aparticularly egregious example was the relationship between Arthur Andersen andEnron.

One other logical consequence of the shrinkage in profit margins for auditing wasthe diversification of the big accountancy firms into (particularly) management

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consultancy, in order to pursue non-audit profitability. Whilst this may have beenlogical, it of course represented an even starker COI, as a number of writers havepointed out over the years (see, for instance, Levitt, 2002); providing managementservices to a firm for which one also had responsibility for auditing was a directconflict and yet the practice grew and was subjected to very little effective regulation.As a direct result of the increasing influence of the big firms over accountancyinstitutions, as well as increases in direct political influence in the US and UKgovernments, initiatives to regulate auditor/client relationships by bodies such as theAuditing Practices Board in the UK and the Securities and Exchange Commission inthe USA were stillborn, whilst the big accountancy firms continued to insist that if nodirect evidence of COI could be produced, then none existed – even after incidents suchas the destructive development of the relationship between Arthur Andersen andEnron.

The institutionalisation and sanctification of COI by accountancy firms which wehave briefly examined also took place at the same time as the explosion in numbers,types and complexity of financial derivatives outlined above. Auditors of coursebecame involved in the trade in derivatives through the auditing service which theyprovided to financial services and banking institutions, only here the problems and theovert COIs were worse. Firms were being paid to audit banks/financial services firmsto whom they were also contracted, in order to “properly audit” capital, cash flow andassets of the bank/firm, to asses the “fair value” for existing and new derivativeproducts, a value which was arrived at by using selected information from andmodelled by methods provided by the firm itself – effectively a perfect storm of COI.As discussed above, however, derivatives have increasingly been constructed todetach them from the inherent risk of the original product and the auditors had littleknowledge of the market into which they were sold (where markets actually existed),so as to make the concept of fair value increasingly imaginary – yet it became anincreasingly important factor in marketing these surreal products[4].

With particular reference to the current credit crisis, then, the most relevantinstitutionalized conflict-of-interest for accountancy firms has been this role played inassessing “fair value” for financial derivatives, which will be examined after a briefcontextual analysis; in more general terms (linking into the previous section) auditingservices provided by firms of accountants have been consistently promoted as atechnology for the management of risk (Mitchell and Sikka, 2002, p. 8) whereas thereality of the ways in which auditing has developed in the last three decades of thetwentieth century mean that auditing is in increasing danger of becoming that thing ofwhich it purports to be the cure, i.e. a creator rather than a manager of risk. As evenErnst & Young put it:

. . . mathematically modelled fair values based on management predictions are not fair valuesas that term is generally understood, and their use raises many questions about the reliabilityand understandability of the information (Ernst & Young, 2005, p. 10)

By 2008, however, during the first financial crisis to occur under a predominantly fairvalue regime, opinions seemed to have changed. PricewaterhouseCoopers (2008, p. 9)still believes that: “Fair value measurement does not create volatility in the financialstatements, any more than a pipeline creates what flows through it. It captures and


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reports current market values”. In this reading, the financial statement by the auditoris an objective and neutral analysis of the current state of affairs; there has been nopressure on the auditor to comply with board requirements, there is no close andmutually beneficial relationship between auditor and client, and the informationprovided by the firm (or the model used) is as fair and objective as can be managed.

Despite the massive problems that financial derivatives have already caused and (asrelated above) the sheer volume of those still being traded, the big four accountancyfirms continue to defend fair value calculations as being the best way to assess thevalue of such derivatives. Irrespective of “financial statement volatility, reporting theimpact of risks and the judgements required to develop and implement fair valuemeasures” and “the impact of fair value on regulatory measures of the capitaladequacy of financial institutions” (PricewaterhouseCoopers, 2008, p. 9), “fair valueyields a relevant measure for most financial instruments”. The big accountancy firmsquite rightly point out that there were few complaints from financial services firms andinvestment banks concerning fair value when the markets were forging ahead; thecomplaints (akin to those about short selling) have all occurred since the roll-out of thesubprime initiated financial crisis – which, given what is now known about the waythat CDOs have been put together, is not really relevant to a consideration of whetherthe ways by which fair value is calculated can ever be sufficient for such surrealfinancial instruments.

Markets through the looking-glass

The aide said that guys like me were “in what we call the reality-based community,” which hedefined as people who “believe that solutions emerge from your judicious study of discerniblereality.” . . . “That’s not the way the world really works anymore,” he continued. “We’re anempire now, and when we act, we create our own reality” (Suskind, 2004).

“There is no use trying”, said Alice. “One can’t believe impossible things”. “I dare say youhaven’t had much practice”, said the Queen. “When I was your age, I always did it for half anhour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast”(Carroll, 1871).

This article has examined three themes vital to the present financial crisis:

(1) the development of financial derivatives;

(2) the subversion of risk analysis; and

(3) the co-opting of fair value.

A longer and more penetrative piece would however have covered more themes; thedevelopment of new public management, “revolving-door” government and thecreation of a shadow financial services system offshore, among others. What is obviousfrom even a brief reading of these three themes, however, is that the causes behind thecurrent crisis are multiple, complex and are the reflection of a rapid, massive andsurreal change in the culture of market governance globally – a leap from a“reality-based” market system into one based on imagination.

The development of such an enormous market in financial derivatives has involvedthe global co-optation and active participation of states, multinational andinternational organisations, international financial institutions, professional

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organisations and institutional bodies, governments, civil services, political parties andpolitical actors over a short period of time. If the premises of this article are acceptedthen the willing suspension of disbelief on the part of so many important actorsglobally meant that this crisis was (along with others like it in the future) aninevitability. It is important to remember as well, however, that this was not just awilling suspension of disbelief concerning the market in derivatives, the market inbonds, the housing market and so on, if not a willing suspension of democratic controlby which the governments of the North/West gave up control over their owngovernance to the random vagaries of shadowy market impermanence, animpermanence in which disaster was guaranteed.

It is also highly unlikely that an enculturated ideology of such penetration andextent (in which the self-interest of so many important global actors is involved inpraising the market-emperor’s new clothes) will learn too much from such a crisis.There are too many vested interests in patching up the old system and willing thederivatives market back into life, even though it is extremely likely that there are moreproblems than the infamous “sub-prime” derivatives lurking in these muddy waters.As Plan A, the US government has initiated the Troubled Assets Relief Program underHenry Paulson (ex-CEO of Goldman Sachs) who, along with sundry ex-colleagues fromGoldman Sachs (which accepted $10 billion from the US government as part of the“rescue package”) appointed Neil Kashkari (a former executive of Goldman Sachs)effectively to take charge of the US economy with sweeping powers to use vast sums ofunwilling US taxpayers’ money, outside the reins of legislative understanding andcontrol.

In the light of $680,290,700,000,000-worth of global trade in derivatives, $700 billionto “rescue” the perpetrators of this market looks not only feeble but pointless. Therecession that has already begun in the rich North/West is going to be made longer andharder by a refusal of responsible parties to address fundamental flaws in the system,and the pessimist-savants such as Joseph Stiglitz and Nouriel Rabini are alreadypredicting a prolonged, L-shaped recession of the type experienced by Japan from the1990s up to 2005 (and now again). In the meantime, those same investment bankswhose collapse occasioned sundry rescue packages use those rescue packages to paythemselves pre-collapse era bonuses, continuing to behave as if nothing hadhappened[5].

The enculturated norms of fundamentalist market fantasies have come home toroost – it should be for the last time but it almost certainly will not be. Thedevelopment of market bubbles facilitated by the development of ever-moresophisticated financial instruments has spawned a growth industry and a globalsupport network based on the power of belief, a belief that no government and nomultinational or supranational institution need depend on something as boring andirritating as mere democracy. Instead, politician, minister, president, accountant andCEO alike, all need to take a deep breath, close their eyes and believe six impossiblethings before breakfast.

Notes

1. In this text, market fundamentalism is used to describe that set of beliefs championed byfollowers in the first resort of Adam Smith, Mill, Hulme and then more latterly the Austrian


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school of Hayek, of Reaganomics, Thatcher and Friedman, beliefs championed by powerfulinstitutions such as the Adam Smith Institute in the UK, the American Heritage Foundationand the so-called “Chicago School” of economists.

2. It must also be remembered that the fall of Enron was not the first time questions had beenasked of derivatives; the failure of the hedge fund Long-Term Capital Management in thewake of the East Asia financial crisis in 1997 constituted a prior red light.

3. Simon Heffer, “If we take away risk, then capitalism is finished”, The Daily Telegraph online,19 September 2007.

4. This despite the increasing concern being shown by the Federal Reserve Board over“managerial bias” and the over-inflation of value; see Bies (2004).

5. See, for example, Bowers (2008).

References

Bernanke, B. (2002), “Remarks by Governor Ben S. Bernanke: On Milton Friedman’s ninetiethbirthday”, University of Chicago, Chicago, IL, available at: www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021108/default.htm (accessed 25 October 2008).

Bies, S. (2004), “Remarks by Governor Susan Schmidt Bies to the International Association ofCredit Portfolio Managers General Meeting”, New York, NY, November 18, available at:www.federalreserve.gov/boarddocs/speeches/2004/20041118/default.htm (accessed30 October 2008).

Bowers, S. (2008), “Wall Street banks in $70bn staff payout: pay and bonus deals equivalent to10% of US government bail-out package”, The Guardian, 18 October.

Boyd, C. (2004), “The structural origins of conflicts of interest in the accounting profession”,Business Ethics Quarterly, Vol. 14 No. 3, pp. 377-98.

Carroll, L. (1871), Through the Looking Glass.

Ernst & Young (2005), “How fair is fair value?”, IFRS Stakeholder Series, Ernst and YoungGlobal, London, available at: www2.eycom.ch/publications/items/ifrs/single/200506_fair_value/en.pdf

Haas, D. (2008), “The crushing potential of financial derivatives”, available at: www.marketoracle.co.uk/Article6756.html

Keen, S. (2001), Debunking Economics: The Naked Emperor of the Social Sciences, Pluto Press,Sydney.

Knight, F. (1921), Risk, Uncertainty and Profit, Houghton Mifflin, Boston, MA.

Levitt, A. (2002), Take on the Street, Pantheon Books, New York, NY.

Magill, H. and Previts, G. (1991), CPA Professional Responsibilities: An Introduction,South-Western Publishing, Cincinnati, OH.

Peterson, J. (2008), “‘Where were the auditors?’ In this crisis, nobody asks – because nobodycares”, Re:Balance, October 24, available at: www.jamesrpeterson.com/home/2008/10/where-were-the-auditors-in-this-crisis-nobody-asks–-because-nobody-cares.html

PricewaterhouseCoopers (2008), “Fair value – clarifying the issues: PricewaterhouseCoopers on akey debate in the capital markets”, available at: www.pwc.com/images/us/eng/about/svcs/assurance/PwC-FairValue-ClarifyingTheIssues.pdf

Roubini, N. (2007), “Current market turmoil: non-priceable Knightian ‘uncertainty’ rather thanpriceable market ‘risk’”, RGE Monitor (Nouriel Roubini’s Global EconoMonitor), 15August, available at: www.rgemonitor.com/blog/roubini/210688 (accessed 3 November2008).

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Suskind, R. (2004), “Faith, certainty and the presidency of George W. Bush”, New York TimesMagazine, 17 October.

Tracinski, R. (2002), “The moral basis of capitalism”, Capitalism Magazine, 26 June (see alsoThe Centre for the Advancement of Capitalism, available at: www.capitalismcenter.org).

UNISON (2002), “A web of private interest: how the big five accountancy firms influence andprofit from privatisation policy”, report, June, UNISON, London.

Vaknin, S. (2005), “Moral hazard and the survival value of risk”, Global Politician, Vol. 20,available at: www.globalpolitician.com/2801-economics (accessed 20 October 2008).

Further reading

Sachs, J. (1999), “Going for broke”, The Guardian, 16 January.

Wade, R. and Veneroso, F. (1998), “The Asian crisis: the high debt model vs the WallStreet-Treasury-IMF complex”, New Left Review, Vol. I/228, March/April, available at:www.newleftreview.org/?view ¼ 1947

About the authorJon Cloke is Project Officer for EnergyCentral, an EC funded alternative energy project based inCentral America, and a Research Associate at the Global and World Cities Network based atLoughborough University. He is based in Leicester at present and his research interests includecorruption, the global development of financial services with special reference to microfinanceand the political economy of global cities He can be contacted at: [email protected]


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From demutualisation to meltdown:a tale of two wannabe banks

Robin Klimecki and Hugh WillmottUniversity of Cardiff Business School, Cardiff, UK

Abstract

Purpose – This paper aims to examine the influence of neoliberalist deregulation on the rash ofdemutualisations of the 1990s. It explores the extent to which the demutualisation of two buildingsocieties – Northern Rock and Bradford & Bingley – and their subsequent demise in the wake of thecredit crunch exemplify key features of the neoliberalist experiment, with a particular focus on theirpost-mutualisation business models.

Design/methodology/approach – The analysis draws on literature that examines the neoliberaldevelopment of the financial sector and examines the media coverage of the financial crisis of2007/2008 to study the discursive and material conditions of possibility for the development andimplosion of the business models used by Northern Rock and Bradford & Bingley.

Findings – The paper argues that the demutualisation of Northern Rock and Bradford & Bingleywas part of a broader neoliberal movement which had processes of financialisation at its centre. Byconverting into banks, former building societies gained greater access to wholesale borrowing, to newtypes of investors and to the unrestricted use of financial instruments such as securitisation. Thecollapse of Northern Rock and Bradford & Bingley is interpreted in the light of their access to thesenew sources of funding and their use of financial instruments which were either unavailable for, orantithetical to, the operation of mutual societies.

Research limitations/implications – The paper comments on the contemporary features andcurrent effects of the 2007/2008 crisis of liquidity, whose full long-term consequences are uncertain.Further research and future events may offer confirmation or serve to qualify or correct its centralargument. The intent of the paper is to provide a detailed analysis of the conditions and consequencesof building society demutualisation in the context of the neoliberal expansion of the financial sectorthat resulted in a financial meltdown. It is hoped that this study will stimulate more critical analysis ofthe financial sector, and of the significance of financialisation more specifically.

Originality/value – The paper adopts an alternative perspective on the so-called “subprime crisis”.The collapse of Northern Rock and Bradford & Bingley is understood in relation to the expansion, andsubsequent crisis, of financialisation, in which financial instruments such as collateralized debtobligations and credit default swaps were at its explosive centre, rather than to the expansion ofsubprime lending per se. Demutualisation is presented as a symptom of neoliberalism, a developmentthat, in the UK, is seen to have contributed significantly to the financial meltdown.

Keywords Building societies, Banks, Debt, Mortgage default, United Kingdom


It has been utterly, unbelievably, astonishing. Seeing the swift disappearance of the formersocieties in the firestorm, which I don’t claim to have predicted, has also been astonishing(Adrian Coles, Director General, Building Societies Association, quoted in Pollock, 2008a).

IntroductionMortgages and their providers have been at the centre of the current financialmeltdown. In the USA, Fannie Mae (Federal National Mortgage Association) and



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Freddie Mac (Federal Home Loan Mortgage Corporation) have been placed in theconservatorship of the Federal Housing Planning Agency. In the UK, the governmenthas intervened to nationalise or part-nationalise a number of banks, including twospecialist mortgage providers: Northern Rock and Bradford & Bingley. Thisintervention is a significant and integral part of a much bigger national and globalpicture. On 8 October 2008, the UK Chancellor announced that the government wouldbe easing problems of liquidity (and ultimately solvency) threatening the survival ofthe other UK banks by making available £25bn to buy preference shares (in banks) orpermanent interest-bearing bonds (in building societies), with another £25bn onstandby. In addition, £200bn was being made available to banks to borrow with afurther £250bn of debt being offered to enable the banks to refinance their loans. At thetime of writing (the end of October 2008), the ill-defined strings attached to these loans,in the form of appeals to the banks to limit executive bonuses and assist businesses,have proved to be elastic and difficult to deliver, the suspicion being that banks areusing them to patch up their own balance sheets rather than to reopen flows of credit toborrowers, including businesses as well as actual and potential homeowners[1].

Northern Rock and Bradford & Bingley were, until the mid-1990s, mutual buildingsocieties[2], owned by and accountable to their members. At that time, there were over100 independent societies. During the past 15 years, this number has diminished toaround 50, mostly as a consequence of merger rather than demutualisation. A minorityof societies, of which many were the largest mutuals, changed their ownershipstructure following a change and relaxation of regulations that began in the mid-1980sand continued through the 1990s. They converted into proprietary banks owned byand accountable to shareholders. Amongst these societies was Abbey National, whichwas the first to convert in 1989. It was later followed by a rash of conversions around1997 when the Halifax, Woolwich and Alliance and Leicester converted. Today, none ofthese demutualised institutions exist[3]. Amongst these converters, Northern Rock andBradford & Bingley prospered as wannabe banks as they expanded in a decade ofabundant credit which fuelled a buoyant housing market where the supply ofmortgages outstripped demand and competition between banks and building societiesintensified[4].

In the following commentary, we explore the connection between demutualisationand the adoption of unsustainable lending practices and associated business modelsthat, we contend, are symptomatic of global financialising frenzy and a subsequentmeltdown exemplified in the seemingly limitless rise and then precipitous fall of theUK’s demutualised banks. We interpret this trajectory as an outcome of a neo-liberalexperiment that, in the name of individual freedom, was constructed to revive theflagging fortunes of capitalism following an extended period of stalled growth duringthe 1970s. What this meant in terms of post-demutualisation[5] business practice canbe briefly illustrated by comments made by a senior figure who worked for one of theproprietary banks during the first half of 2007 when cautious, mutual lenders likeNationwide cut back on their loans whilst the loan books of Northern Rock andBradford & Bingley grew to record levels:

Pulling back from the mortgage market now looks to have been a really smart bet, but wewould have felt very uncomfortable with a strategy based on giving up market share andreducing lending. As it turns out, our shareholders would probably have thanked us for thatapproach, but we would never have risked the investor fury such a slowdown in sales would

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ordinarily produce (Comment from a senior figure at a PLC bank reflecting on decisions takenin the first half of 2007; quoted in Prosser, 2007).

The neoliberal revival project was sold to UK and US electorates by the charismaticpolitical figureheads of Reagan and Thatcher, and it was sustained thereafter by theClinton and Blair administrations. As Blair’s Chancellor confidently crowed inNovember 1997:

I am satisfied that the new monetary policy arrangements will deliver long-term pricestability, and prevent a return to the cycle of “boom and bust” (Gordon Brown, formerChancellor of the Exchequer, quoted in Finkelstein, 2008).

The neoliberal formula for reviving capital accumulation has pushed relentlessly forthe sovereignty market discipline and mechanisms (e.g. stock options and bonuses) asa replacement for failed Keynesian corporatism and state regulation. The goal has beento ensure a restoration and sustained reproduction of established structures ofadvantage that has been accomplished, in part, through the formation of new elites(Murphy, 2008), predominantly in the financial sector where those dubbed by Keynesas “coupon clippers” have enjoyed, at least until the meltdown began in 2007, aspectacular resurgence. Central to this process was a transfer of public assets to theprivate sector that has been a condition and a consequence of the rapid expansion offinancial activity:

Increasingly freed from the regulatory constraints and barriers that hitherto had confined itsfield of action, financial activity could flourish as never before, eventually everywhere. Awave of innovations occurred in financial services to produce [. . .] new kinds of financialmarkets based upon securitization, derivatives, and all manner of futures trading.Neo-liberalization has meant, in short, the financialization of everything (Harvey, 2007, p. 33,emphasis added).

With so much finger-pointing at “reckless lending” in the subprime mortgagemarket as the apparent root cause of the meltdown in financial markets, it isperhaps unnecessary to say that this “everything” includes housing. What is muchless evident is that mortgages, in the form of mortgage-backed securities (MBS), aform of collateralised debt obligation[6] (CDO), became a primary and highlyprofitable target of financial engineering. It is not simply that many people weresold loans that they would struggle to service when interest rates increased andproperty values stalled or fell. Rather, it is the way in which these loans werepackaged up as MBSs as a basis for making further loans which, in turn, created ahuge, unregulated market in credit default swaps[7] to hedge, or bet, against therisk of default on the MBSs. In the UK, a condition of possibility of such engineeringwas the relaxation of regulations enabling building societies to demutualise, andthereby gain increased access to wholesale markets[8]. Proprietary banks,including demutualised societies, have both greater access to, and considerableshareholder pressures to use, the wholesale markets as a means of expanding thescale and profitability of their businesses. Our commentary makes connectionsbetween “the financialization of everything” that includes home loans, thedemutualisation of building societies, and the business models that relied upon theavailability and reliability of sophisticated financial instruments. It is organisedaround three questions:

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(1) Why did many building societies demutualise?

(2) What effects did demutualisation have upon the business models of thedemutualised companies?

(3) What were the key elements of the neoliberal experiment that resulted in thefinancial meltdown exemplified in the demise of the demutualised banks?

Why did many building societies demutualize?The UK Building Societies Act 1986 formed part of a series of neoliberal measuresintended to stimulate economic activity by increasing competitiveness througheconomic deregulation. In essence, the option for building societies to demutualise,which formed part of the “Big Bang” deregulation of the financial services industry,was expected to make mortgages cheaper and more widely available and furthercontribute to the breaking of the monopoly of building societies in the mortgagemarket, thereby contributing to the development of a property-owning democracy inwhich, in principle, everyone has a personal investment in the unhinderedreproduction of the capitalist system. In the neoliberal symbolic universe, thepromotion of “individual rights” functions as a central nodal point around whichnecessity of the preservation of strong property rights, and their protection by thestate, is structured (Harvey, 2007). Neoliberalism also promotes the use of stockincentive schemes to bridge the classic dividing line between ownership andmanagement of companies, and prioritises financial over productive capital. In thissense, the demutualisation drive that occurred in the 1990s, facilitated by anexpansion of securitisation in the mortgage market (in which demutualised societiesbecome key players), formed an integral part of a process of financialisation which,in its broadest sense, has been characterised as the “increasing role of financialmotives, financial markets, financial actors, and financial institutions” (Epstein,2006 p. 3). Notably, the demutualised societies become more fully hedged financialinstitutions able to wholly embrace financial motives and participate morecompletely in financial markets.

Before the 1986 Act, corporate governance of mutuals had relied on an “identity ofinterest” between lenders and borrowers. The prospect of demutualisation permitted –indeed encouraged – this connection to be severed. Why was demutualisation anattractive option? For the members of these mutual societies, there was the appeal of asubstantial windfall that could amount to thousands of pounds, by signing a votingform which changed them from policy-holders into shareholders. For those whoorganised campaigns to demutualise the societies, there was the prospect of gainingcontrol of considerable assets. These campaigners drew support from“carpetbaggers”[9] who invested in a society simply to be able to vote forconversion and thereby obtain windfall gains. Conservative and Labouradministrations actively supported the demutualisation process. Notably, when thecourts found a way of circumventing the qualifying two-year period for a member tomake equity claims, intended as an anti-carpetbagger provision in the 1986 Act, thethen Conservative government did not enact amending legislation to counteract thisdevelopment (Tayler, 2003).

But it was not just the account holders, campaigners and carpetbaggers whosought the demutualisation of the societies. Numerous advisers and intermediaries– accountants, lawyers, investment bankers – pitched for the handsome fees for

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facilitating demutualisation. Finally, and most crucially, the directors of the mutualsstood to enhance their status as well as their rewards package as a consequence ofconversion. For them, there was the prospect of mutating from low-profile mutualbuilding society executive to director of a PLC bank, with the higher salary,bonuses, share options as well as the elevated status. And there was also theprospect of the pay-off accompanying acquisition by another financial institution.As Christopher Rodriques, Chief Executive of Bradford & Bingley at the time ofdemutualisation, is reported to have said:

When we float we are obviously responsible to shareholders and would look at any one whocomes along with a large, cleared cheque (quoted in Ashton and Dey, 2008).

Bradford & Bingley’s directors were actually resistant to demutualisation butproved insufficiently well prepared and organised[10], unlike the Nationwide andBritannia, to resist it. At Nationwide, in contrast, the Chief Executive led adetermined campaign that lasted several years to fight off carpetbaggers (BrianDavies, Chief Executive, Nationwide; quoted in Griffiths, 2001).

Opponents of conversion were treated with derision in the popular media.Resistance by directors was interpreted as backward-looking, over-cautious andinattentive to their policy-holders, who would benefit from access to more diversifiedservices, competitive loans and so on. As The Times put it, “opponents were comparedto ‘steam train enthusiasts’, hopeless romantics trying to save a business model thathad no place in electrified modern capitalism” (The Times, 2008).

In these conditions, it is not the number of conversions by the larger societies but,rather, the societies that avoided or resisted demutualisation which is remarkable,especially as those expressing doubts about the benefits tended to be publiclyridiculed. Commenting upon the demutualisation craze, an analyst of building societiesfor the investment bank UBS observed:

They used words like “freedom to compete” and “access to capital,” but the main reasonswere excessive pay, share options and testosterone’ (John Wrigglesworth, Building Societyanalyst for the investment bank UBS in the 1990s; quoted in Pollock, 2008a).

This underlines a certain attraction and excitement for the stock market that doesnot necessarily correspond to claims of efficiency (see Staheli, 2007). As others haveargued, processes of financialisation are a medium and outcome of a neoliberalsymbolic universe in which it is assumed that financial markets are the best judgesof what is economically beneficial. Financial markets, Argitis and Pitelis (2008, p. 4)have suggested, may behave in a way that “their own ‘beliefs’ are imposed on thereal economy, acting as self-fulfilling prophecy [. . .] Financial markets [. . .] maycreate their own ‘fundamentals’”. Companies, but also governments, then areobliged to prove their credibility according to the confidence that financial marketsshow in them. Conversely, when they are assessed to fail to warrant such confidence(see Gill, 1995), there is capital flight regardless of the impact upon consumers andcitizens. If the flight continues, then either the company becomes bankrupt as itscredit drains away, or it is rescued by the states as the lenders of last resort, as hasoccurred in the cases of Bear Stearns and AIG, as well as Northern Rock andBradford & Bingley.

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What effects did demutualisation have on the business models of thedemutualised companies?

. . . the most vulnerable building societies are those that have the greatest exposure tospecialist mortgages, high loan-to-value residential mortgage loans, concentration incommercial mortgage lending and recent rapid loan growth (Ferreira-Marques, 2008,referring to Fitch rating agency report on UK Building Societies, July 2008)[11].

Following the Big Bang deregulation and liberalisation of the financial servicesindustries during the 1980s and 1990s, the market for mortgages in the UK underwenta seismic shift. From a situation where rather sleepy mutual building societies haddominated the market by providing similar, simple products on cautious terms,product offerings became more diverse and complex. Reflecting upon this period, arecent commentary in the Financial Times recalled how “Britain’s mortgage bankschanged their business model and become heavily reliant on wholesale banking andsecuritisation. It was a mile away from the original Friendly Society model that lent outonly what the members had deposited” (Augar, 2008).

Under the Building Societies Acts of 1986 and 1997, mutuals were required to deriveat least 50 per cent of funding from member deposits and to secure 75 per cent of theirassets in residential property (Heffernan, 2005). This restriction opened up anopportunity for demutualised societies to increase their share of this market by makingloans funded by borrowing from wholesale markets, especially during an era ofabundantly cheap credit, to which the mutuals have comparatively limited access[12].As the market mechanism kicked in, established building societies becameincreasingly aggressive in competing with new entrants, in the form of the banks,which now included the ex-mutuals. Products were often designed to win businessfrom competitors by offering fixed rates and/or by lowering tariffs for the first year ormore of the loan. So, in addition to the “churn” associated with the use of introductoryoffers developed to tempt “prime” borrowers away from their existing loan providers,there was pressure to develop ways of penetrating “subprime” sectors – that is,reaching potential customers whose employment, credit or business record hadpreviously excluded them from entering the housing market and thus from fullyreaping the rewards of participation in a property-owning democracy. At the sametime, on the supply side, there was both pressure and opportunity to supplementtraditional sources of finance (that is, retail deposits) by going to the wholesalemarkets, which during this period were often awash with money prompted, insubstantial part, by the dicing, packaging and sale of mortgages as mortgage backedsecurities (MBS)[13] available at low rates of interest.

Intensifying competition and unparalleled growth fuelled by low interest rates andinnovative products were hallmarks of the decade leading up to 2007. Responsive toshareholder pressure and executive ambition, growth was led by those demutualisedsocieties that specialised in mortgages, notably Northern Rock and Bradford &Bingley, and by banks that had acquired or merged with demutualised societies[14]. Ofthese, HBOS, formed through a merger of the demutualised Halifax Building Societyand Bank of Scotland, was the dominant player. When considering the rise and fall ofNorthern Rock and Bradford & Bingley, it is relevant to consider the fate of HBOS asits business model combined elements that they favoured – namely, reliance uponwholesale markets (Northern Rock) and/or specialisation in subprime market segments(Bradford & Bingley).

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In 2006, HBOS was one of the first lenders to introduce a 125 per cent mortgageproduct, ostensibly tailored to young professionals who were struggling to get afoothold on the property ladder but had high future earning potential. In the same year,HBOS issued a Corporate Social Responsibility Report in which it trumpeted its recordas the best performing bank stock over the past three years (HBOS, 2006). A total of 18months later, it was ignominiously part-nationalised, with the humiliating prospect ofbeing rescued, at a knock-down price by Lloyds TSB. In October 2008, Bradford &Bingley was described as “a busted flush, a bank that has become so dependent on thewholesale markets and a business model created around weak sectors that a merger isnot only inevitable but desirable. The alternative is full nationalisation or failure”(Murden, 2008)[15].

This diagnosis of HBOS’s business model and prospects echoes assessments ofNorthern Rock and Bradford & Bingley. HBOS is not only dependent upon wholesalemoney markets, as was Northern Rock and Bradford & Bingley, but was also exposedto risky housing, property and corporate lending markets, which has made it anunattractive proposition for nationalisation. At the right price, HBOS is nonetheless anappealing acquisition for Lloyds TSB, for whom the government, in order to avoidtaking ownership of this sizable financial problem, was willing to bypass the mergerrules which allow regulators to scrutinise and even block anti-competitive deals(Shoosmiths, 2008).

Northern RockAt its peak, Northern Rock had become the eighth largest British bank. As 2007arrived, it was seemingly riding high and, in June 2007 when its share price stood at1,000p, it announced that it had sold mortgages worth £10.7bn, up 47 per cent on thesame period in 2006[16]. Since its demutualisation in 1997, the Rock had grownrapidly[17] to become the fifth largest mortgage lender in the UK. It funded itsaggressive expansion by heavy reliance on secured and unsecured borrowing, withabout 50 per cent of its funding coming from securitization through its special purposevehicle, Granite. Retail deposits and funds had fallen from 62.7 per cent at the end of1997 to 22.4 per cent at the end of 2006. Despite its reliance on the wholesale sector, andas opposed to other banks, it did not insure itself sufficiently against the potential lossof liquidity (House of Commons Treasury Select Committee, 2008a). At the end of June2007, former CEO Adam Applegarth explained its funding model, which was latercalled “a highly leveraged bet on interest rates” (House of Commons Treasury SelectCommittee, 2008b, Q 401), as follows:

We do most of our borrowing in the wholesale markets based on Libor (London InterbankOvernight Rate)[18] but most of our lending is related to base rates. Over the last five monthsthe gap between the two has been getting steadily wider, to the extent it was 69 basis pointsat one stage. That means that as interest rates rise our margins get trimmed. Conversely,when they fall they flatter our margins (Adam Applegarth, former CEO, Northern Rock,quoted in Goodway, 2007).

In 2006, through a deal with Lehman Brothers, the Rock moved into subprime lendingbut, in contrast to Bradford & Bingley (see below), this did not become a major part ofits activities. A key distinguishing characteristic of the Rock’s business model was itsexceptionally high level of dependence upon, and exposure to, wholesale moneymarkets, particularly in terms of securitising its mortgages. During the first half of

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2007, Northern Rock expanded its business very rapidly as its net loans to customersincreased by £10.7bn during this period (House of Commons Treasury SelectCommittee, 2008a). Following an increase in interest rates and an associatedslow-down in house price inflation, the Rock issued a profits warning on 27 June 2007.Commenting upon the position, Adam Applegarth anticipated that profit growthwould nonetheless be within the company’s targets of 15 per cent to 25 per cent for thesecond half of 2007, although more likely at the lower end of this range. He remainedsufficiently confident to raise targets again in the medium term (Wearden, 2007;Attwood, 2007). And, in this, he was supported by most analysts, such as GoldmanSachs, who were, at that time, making “buy” or “hold” recommendations (Fletcher,2007).

In early August, following BNP Paribas’s decision of the 9th to suspend funds thathad exposure to the US subprime market, the money markets started to dry up. At thistime, Northern Rock’s exposure to the wholesale market (mostly securitisation, coveredbonds and unsecured wholesale funding) was 73 per cent, while the wholesale exposureof Bradford & Bingley and HBOS was 42 per cent and 43 per cent, respectively[19] (TheTelegraph, 2007).

As the credit squeeze tightened, only the big diversified banks were able to raisewholesale funds, and they were finding it increasingly difficult and expensive. Withina week, officials at the Financial Services Agency and the Treasury alerted theGovernor of the Bank of England to the effects of the credit squeeze on the Rock. On 4September, the severity of the credit drought became evident as the Libor rose to itshighest level in nine years. In similar circumstances, the European Central Bank andthe Federal Reserve had moved to ease liquidity by pumping huge amounts into thebanking system. In contrast, in the UK, the Governor focused upon the moral hazard ofbailing out reckless lenders rather than upon the potential systemic risk associatedwith a reluctance to ease liquidity. This view was subsequently moderated, but notreversed, on 13 September when the Rock was granted emergency financialsupport[20].

The possible limitations of a business model that relied upon the wholesale moneymarkets had actually been signalled by Northern Rock’s communications director,Brian Giles, in August 2007 when he reported increasingly difficult trading conditions,though he added that “It has been a tough time in the credit markets, but we raised a lotof liquidity ahead of this turbulent period” (Brian Giles, Communications director,Northern Rock; quoted in BBC Business, 2007). A month later, the day after the Bank ofEngland had granted it emergency funding, the Rock’s share price dived by 32 percent. In response, experts opined that “Northern Rock, which has £113bn in assets, isnot in danger of “going bust’”. But customers clearly had their doubts, precipitating arun on the bank as they stampeded to withdraw their savings (BBC News, 2007). Sixmonths later, in February 2008, Northern Rock collapsed after acquisition bids by theprivate sector (e.g. Virgin and Olivant) were eventually rejected by the government,and it was taken into public ownership.

Bradford & BingleyBradford & Bingley, formed in the mid-1960s from the Bradford Equitable BuildingSociety and Bingley Permanent Building Society, was the UK’s second largest buildingsociety prior to its demutualisation in 2000. In March 2006, the bank was valued at

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£3.2bn. By 20 September 2008, it was worth £256m and, like Northern Rock, it wasnationalised as the government took control of the bank’s £50bn mortgages, and its£20bn savings unit and branches were sold to the Spanish bank Santander which hadpreviously acquired Abbey and Alliance & Leicester. The combined costs ofnationalising Bradford & Bingley and Northern Rock have been estimated to result inevery British taxpayer shouldering a burden equivalent to £5,500 in mortgage debt(Davies, 2007).

In a briefing on 21 June 2007, the CEO of Bradford & Bingley, Stephen Crawshaw,reported:

We’ve had an excellent start to the year marked by very strong growth. Prospects remaingood for the second half as demand continues to drive the buy-to-let market. Increasingreturns to shareholders through organic growth, portfolio acquisitions, and capitalmanagement will be our focus for the remainder of 2007 (Bradford & Bingley, 2007a).

A week earlier, Standard & Poor had identified Bradford & Bingley as being atparticular risk from higher interest rates because it was a subprime lender (Ram, 2007).In November 2007, just two months after the run on Northern Rock, Crawshaw wasreported to say that despite the market turmoil, the bank had been “resilient andresourceful” and was “now even better placed to take up opportunities in the markethaving disposed of its non-retail portfolios in line with its focus on retail mortgagesand saving” (quoted in Murchie, 2007). It was also announced that net new lending,albeit lower than in June, was higher than a year ago and that confidence remained inthe buy-to-let market (Bradford & Bingley, 2007b). Less than 12 months later, inSeptember 2008, the bank collapsed and its mortgage book was nationalised.

Bradford & Bingley’s business model comprised a number of distinctive features. Itwas unique in being an independent intermediary in advising on and selling otherproviders’ mortgages in addition to its own offerings. Another feature was apropensity to diversify by purchasing businesses (e.g. estate agencies) and then sellingthem within a few years, often at a substantial loss. Notably, Bradford & Bingley paid£100m for the independent mortgage broker John Charcol in 2000. Four years later itwas negotiating Charcol’s sale for £10m. Unlike Northern Rock, Bradford & Bingleyhad increasingly specialised in buy-to-let and self-certified mortgages sold through itsinternet business Mortgage Express[21] that it had purchased from Lloyds TSB in1997. Bradford & Bingley also bought large, risky but high-yield loan portfolios fromGeneral Motors in an attempt to increase its profitability. And in a further effort tosatisfy its investors, Bradford & Bingley repeatedly slashed costs by cutting thepayroll (UK Business Park, 2008).

After Northern Rock and HBOS, Bradford & Bingley was most reliant upon, andexposed to, the wholesale market for its funding, which it used to engage in riskier (e.g.sub-prime) forms of lending (Aldrick, 2008). Prior to 2007, when efforts were made toreduce its dependency, about 60 per cent of its business was funded through thesemarkets (The Economist, 2008). When interest rates were low and house prices wererising apparently irreversibly, this proved to be a winning formula. In early 2006, thecompany’s shares rose to 500p. In the first half of 2007, net lending at Bradford &Bingley increased by 92 per cent to reach a record high of £4.5bn, growth that waslargely funded from the wholesale market rather than from retail deposits (YorkshirePost, 2007). Pressed by the demands of its shareholders and the ambitions of itsdirectors, notably the chief executive, this stratagem was unequivocally embraced as a

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“compelling route [as] the bigger banks had cornered the market in offeringcreditworthy borrowers the best deals” (Ashton and Dey, 2008).

From mid-2007, the buy-to-let market, usually financed with debt, was badlyaffected by the drying up of credit and subsequent stalling and falling of the housingmarket, since activity in this segment is premised upon the presupposition of risingproperty values and rising rents. Indeed, Bradford & Bingley warned at the beginningof June 2007 that the sector was in crisis (Property Wire, 2008). As credit tightened andthe cost of loans increased, landlords fell behind with payments. Compounded by anincrease in mortgage fraud in the self-certification sector, Bradford & Bingley’s profitsfell from £108m to £56m in the first months of 2008 compared to the same period in2007 (Atkinson, 2008)[22]. In June 2008, there was a decline in its share price of 30 percent. To increase liquidity Bradford & Bingley went to the market with a rights issueintending to raise £300m. This was initially priced at 82p per share but reduced to 55p,the level at which it was able to get a private equity group, TPG, to make up theshortfall by taking at 23 per cent stake. The deal with TPG then fell through asBradford & Bingley’s fortunes further deteriorated and Moody’s cut the bank’s creditrating[23]. Nonetheless, on the Friday before the bank’s collapse and its nationalisationthe following Monday when it was unable to continue funding its operations (and wasnationalised), a spokesperson for the bank was reported to have insisted that:

We are fully-funded and we are one of the strongest capitalised banks in the UK. As far as thefebrile speculation goes, we do not comment on market rumours (Wallop and Griffiths, 2008).

Depositors believed otherwise, as £90m was withdrawn on the Saturday morning anda further £200m was withdrawn from internet accounts by the following Monday.

To recap, for Northern Rock and Bradford & Bingley, as well as HBOS, an effect oftheir demutualisation was pressure to develop a business model that would producedividends and capital growth for their shareholders:

There is a class of banks, all of them former mutuals that relied heavily on the mortgagemarket, Northern Rock, HBOS and Bradford & Bingley. The remaining banks have broader,more diversified, bases (BBC News, 2008).

Northern Rock was not a major player in the subprime markets compared to HBOS andBradford & Bingley. Nor did Northern Rock diversify, for better or worse. Instead, theRock relied very heavily upon the securitisation of its assets, in the form ofmortgage-backed securities (MBSs) that in turn relied upon funding through wholesalemoney markets. While Northern Rock relied most heavily upon securitisation to fuel itsprofitable growth, securitisation was also a central plank of the Bradford & Bingley(and HBOS) funding models although, in their case, it was lending in subprime marketsthat contributed to their nationalisation (Bradford & Bingley) or expected takeover (ofHBOS by Lloyds TSB).

What were the key elements of the neo-liberal experiment that resulted inthe financial meltdown exemplified in the demise of the demutualisedbanks?

And then came the housing boom [. . .] mortgage-backed securities became the hot newinvestment. Mortgages were pooled together, and sliced and diced into bonds that werebought by just about every financial institution imaginable. For many of those

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mortgage-backed securities, credit default swaps were taken out to protect against default(Philips, 2008).

An important but often overlooked condition of possibility of the financial meltdownhas been the policy of the Chinese government to build up currency reserves,principally in dollars. This kept interest rates down as its dollars were then lent to theglobal capital markets. This supply of cheap credit fuelled subprime lending that,along with other loans (e.g. credit cards and the financing of big ticket items such ascars), inflated the debt bubble. But it was not cheap money alone that unleashed thecredit binge. It was the financialisation of the debt – that is, the use of financialinstruments, notably collateralised debt obligations (CDOs) in the form of mortgagebacked securities (MBSs), to transmute and leverage seemingly fixed assets intoliquidity that could then be used to make further loans that would again be securitisedto make further loans, and so on. Financial engineering also created new risksassociated with the uncertainty as to whether the obligations would be honoured, thusgiving rise to the development of a further tier of instruments called credit defaultswaps (CDSs). Common to both types of instrument is their privately negotiatedcharacter, the absence of regulation and the lack of a central reporting mechanism tocalculate their value.

CDOs involve the packaging up of assets that are sold as securities through specialpurpose vehicles (SPVs). A total of 50 per cent of Northern Rock’s funding camethrough securitisation using a special purpose vehicle (SPV), Granite (House ofCommons Treasury Select Committee, 2008a). SPVs enable banks to tap the capitalmarkets by securitizing a pool of assets (mostly MBSs, in the case of Northern Rockand Bradford & Bingley) by bundling together claims to future obligations ofmortgage repayments such as principal and interest (Langley, 2006). The appeal ofCDOs lies in the removal of illiquid assets from balance sheets. By selling on theseassets to other financial institutions, which include insurance companies and pensionfunds as well as other banks, banks are able to restore liquidity. This has beendescribed as a “tower of debt” that is:

. . .made of the original sub-prime loans that have been piled together [at the top of this toweris the AAATranche, just below it is the AA Tranche, and so on down to the riskiest, the BBBTranche . . . The banks had used these BBB Tranches] – the worst of the worst – to build yetanother tower of bonds: a “particularly egregious” CDO. The reason they did this was that therating agencies, presented by the pile of bonds backed by dubious loans, would pronouncemost of them AAA. These bonds could be sold to investors – pension funds, insurancecompanies – who were allow to invest only in highly rated securities.

As Steve Eisman, a speculator who anticipated the meltdown and has made a hugefortune from shorting, or betting against, CDOs has commented the banks “weren’tsatisfied getting lots of unqualified borrowers to borrow money to buy a house theycouldn’t afford [. . .] They were creating them out of whole cloth. One hundred timesover! That’s why the losses are so much greater than the loans” (Lewis, 2008).

The Basel I and II accords of 1988 and 2004, issued by the Basel Committee ofBanking Supervision, had been intended to strengthen banks’ balance sheets byrequiring them to weight assets according to their risks (FSA, 2008). But thisrequirement has had the unintended consequence of incentivising banks to devisemeans of removing risks from balance sheets rather than making them more

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transparent. Instead of deriving most of their income primarily from the spreadbetween the cost of their borrowing (e.g. from depositors) and their lending (to theircreditors), fees and commissions from securitisation have become increasinglyimportant. Commenting upon this development, Chick (2008, p. 121) observes that “(a)banks no longer have an on-going interest in, or capacity to monitor, the loans theymake and (b) with repackaging, it is very difficult to evaluate the risk of claims onthese loans”.

Whereas banks once had good reason to pay close attention to the risk of their ownassets, securitisation has meant that this risk passes to those who buy CDOs (see Mianand Sufi, 2008). In principle, the rating agencies evaluate these assets but they are paidto do so by the banks and they do not bear the costs if their scoring is found to beover-optimistic. For example, Standard and Poor rated Bradford & Bingley as “astrong institution with good asset quality” in September 2007[24].

It is the difficulty of evaluating the risk of claims on CDOs that has stimulated thecreation of an insurance market, in the form of CDSs. To hedge against, or place a beton, CDOs losing their value (i.e. producing negative equity for retail lenders such ashome owners and for the financial institutions buying the securitized loans), financialengineers have developed instruments for mitigating this risk. JP Morgan was the firstbank to introduce a CDS desk in 1994. By 2008, it was estimated to have become a$50-60 trillion market. Like CDOs are subject to infinite resale. CDSs have beenfamously described by Warren Buffet as “financial weapons of mass destruction”because if the insurer does not have the resources to pay the buyer, the buyer is notcovered for any losses on the CDO[25].

Furthermore, the existence and size of the CDS market attracts risk speculators,such as Steve Eisman (see above). They buy CDSs for companies that they assess tohave a good chance of defaulting on CDOs. Conversely, a speculator might calculatethat default is highly unlikely and therefore obtain and sell a CDS in the expectationthat premiums will be collected with minimal chance of having to pay out on insuranceclaims. Bear Stearns and AIG had trillions of dollars of CDSs on their books, leavingtheir trading partners exposed to their possible default – which is what explains theswift intervention of the Federal Reserve to limit the damage by issuing loans whichthese companies have been required to service at a premium rate. This might seemrather irrelevant in relation to the fortunes of UK demutualised building societies, butCDSs are written on subprime mortgage securities. As Shah Gilani has commented:

It’s bad enough that these sub-prime mortgage pools that banks, investment banks, insurancecompanies, hedge funds and others bought were over-rated and ended up fallingprecipitously in value as foreclosures mounted on the underlying mortgages in the pools.What’s even worse, however, is that speculators sold and bought trillions of dollars ofinsurance that these pools would, or wouldn’t, default. The sellers of this insurance (AIG isone example) are getting killed as defaults continue to rise with no end in sight (Gilani, 2008).

The fate of the demutualised UK banks has been sealed by the loss of confidence in themarkets for CDOs and CDSs that has produced a volte face by banks as, in an effort toshore up their balance sheets, they have hoarded cash, including that made available tothem by central banks. A preoccupation with their liquidity has been prioritised abovemaking loans to the likes of Northern Rock whose business model, with its extremereliance upon securitization, was assessed to be ill-equipped to survive a downturn.When the market for securitisation dried up in the wake of the so-called “subprime

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crisis” – a crisis which, we have suggested, is better understood as a crisis of thefinancialisation dominated by the explosive growth of (now toxic) CDOs and CDSs –exposure to the risks associated with these instruments has led banks to retain theirassets in order to preserve liquidity and avoid insolvency. Those wannabe banks –Northern Rock, Bradford & Bingley and also to a lesser degree HBOS – have beenunable to transform their highly illiquid assets into the cash required to fund theirongoing business. When they have not collapsed and been nationalised, they have beenrescued and propped up by government loans in the form of preference shares. Incontrast, the business models favoured by proprietary companies were simplyoff-limits to mutual building societies, which are subject to guidelines and monitoringby the FSA to meet targets of liquidity[26].

Conclusion

The best argument for mutuality is blindingly simple – a building society is owned by itssavers and borrowers, so its sole purpose is to serve them. That goal is not complicated by aconflicting need to satisfy the Square Mile (Sutherland, 2008)[27].

Our central thesis has been that the key to understanding the current financialmeltdown is not the rapid evaporation of cheap credit, popularised as the “creditcrunch”, but the rise of financial instruments, in the form of CDOs and CDSs, that havebeen used to supercharge the borrowing process. Notably, high-risk, “subprime” loanson big ticket items, such as homes, have been securitised to remove them from lenders’balance sheets. In a highly detailed analysis of the role of securitization in the rise ofhome loans in the USA from 2001 to 2005, Mian and Sufi (2008, pp. 22-3) conclude that:

The process of mortgage originators selling and securitizing loans led to a sharp shift in thesupply of mortgage credit. The expansion of supply affected sub-prime customers who weretraditionally marginal borrowers unable to access the mortgage market [. . .] The changescaused a subsequent spike in default rates, which have in turn depressed the housing marketand caused financial market turmoil.

The rapid expansion of derivatives (e.g. mortgage-backed securities) marks a shift to“profit from betting on market chance, rather than growth, which has made financialinnovation a primary driver of the expansion of financialization into ever-increasingareas of social organization” (Montgomery, 2006, p. 305). As we noted earlier, NorthernRock’s business model was characterised as “a highly leveraged bet on interest rates”.Derivatives have grown to become a central feature of a financialised global economyin which “downturns are now likely to result from a loss of confidence in the equitymarket rather than from inflation in the goods market, rapid credit growth overinvestment, and financial imbalances become all important” (Aglietta and Breton,2001, p. 434). Economic crisis now stems from unpaid debts because accumulatedcapital does not require the prior settlement of debts. Bradford & Bingley’s andespecially Northern Rock’s highly geared business models illustrate this point. Thus,the current financial crisis is essentially a crisis and consequence of financialisation assuch (see also Blackburn, 2008).

It is questionable, however, whether the directors of these demutualised companiescould be expected to adjust rapidly and successfully to a very different financial terrainfrom that encountered by mutual building societies. It has been suggested that:

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. . . the individuals running these banks ran slap bang into financialization in its pomp.“Originate and distribute” banking was all the rage. The investment bankers claimed to have“transformed risk” through their credit derivatives, off-balance sheet vehicles andsecuritizations. Governments and regulators were easing off the brakes in respect ofcapital adequacy, disclosure and intervention. Hedge funds moved shareholder activism froma minority pursuit practiced by maverick raiders to a mainstream activity and companiescould not afford to slip. Benign economic conditions and low interest rates encouragedleverage and risk-taking (Augar, 2008).

Beholden to shareholders who prioritised dividends and profitable growth, thedemutualised banks were under great pressure to meet these demands. The stratagemsdevised by Northern Rock and Bradford & Bingley were highly successful in relievingthis pressure, at least in the short-to-medium term. They were compelled to keepissuing home loans funded by the wholesale markets and, in Bradford & Bingley’scase, further increased its already high exposure to the subprime segment at a timewhen the mutuals and more diversified banks (e.g. HSBC, Barclays, Lloyds TSB) hadthe luxury of opting to cut back on their mortgage business. Reflecting uponNationwide’s decision to restrict the issuing of loans in anticipation of a stalling inhouse price inflation, its retail director, Stuart Bernau, stated that “we took the view atthe beginning of this year [2007] that our rivals were driving down pricing, loosingaffordability constraints and sacrificing quality for market share” and went on byemphasising the importance of sticking to a “very basic principle despite losing marketshare, in the light of these developments” (Prosser, 2007). Astute investors in NorthernRock and Bradford & Bingley would have realised that the business models developedby these banks were products of expediency and opportunism that could not besustained when interest rates increased and/or credit tightened. What was moredifficult to anticipate without a working knowledge of the role of securitisation was thespeed at which these businesses would be enveloped and then wiped out in the turmoilof the meltdown.

In periods of high liquidity in money markets, mutuals’ restricted access to thesemarkets makes it more difficult for them to compete with banks, although thishandicap is compensated by the absence of shareholders demanding dividends and/orcapital gains and the associated threat of hostile takeover bids. When liquidity tightensor freezes, mutuals are much less exposed – in two respects. First, their capped relianceupon wholesale money markets inhibits involvement in the sale of subprimemortgages, so their asset base is comparatively protected. Second, when capitalismenters one of its periodic bouts of crisis and panic, mutuals continue in businessbecause their primary source of funds is from retail savers, not the money markets.Indeed, during these periods savers tend to turn to the mutuals precisely because theirbusiness model is, like the steam railway, immune to high-voltage power failures. Overand above these considerations, the primary obligation of directors of these societies isto their policy-holders who are generally risk-averse, passive and to a degree “lockedin”. Mutuals are not beholden to footloose shareholders and speculators who, if theyare sufficiently shrewd, are alert to the limitations of business models that are capableof delivering strong performance only while conditions allow.

Where dark clouds form, there is usually a silver lining. In this case, it is the mutualbuilding societies that have profited from the meltdown of financial markets. Evenfor those, like Cheshire, Derbyshire and Barnsley Building Societies, that have

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encountered difficulties with their loan books, there has been a ready refuge in largersocieties, such as the Nationwide and Yorkshire. In general, mutual societies that hadbeen declared marginal, if not dead, in the wake of the demutualisation wave of the1990s have been the principal beneficiaries of the financial turmoil. As a pertinentindicator of resurgence of the mutuals, in the first half of 2008, they received almostdouble the amount of deposits (£6.3bn) that had been taken in the first half of 2007(The Telegraph, 2008).

Notes

1. The more solvent banks, such as Barclays, have refused the offer, preferring to borrow over£7bn from Qatar and Abu Dhabi even at an interest rate of around 14 per cent compared tothe UK government’s 12 per cent. Why would Barclays want to part-nationalise itself moreexpensively to two Middle Eastern states? The answer would seem to be that it is desperatefor the funds but, unlike most of its rivals, sufficiently strong to pay a premium in order toavoid the risk of having its “commercial freedom” curtailed, including the payment ofsalaries in the single- and even double-figure millions to a number of its executives (Peston,2008).

2. A building society is a financial institution, owned by its members, that offers banking andother financial services, especially mortgage lending. The term “building society” first arosein the nineteenth century, in the UK, from co-operative savings groups: by pooling savings,usually terminating deposits, members could buy or build their own homes. In the UK todaybuilding societies actively compete with banks for most banking services, especiallymortgage lending and deposits accounts. As of 2008, there are 59 building societies in the UKwith total assets exceeding £360 billion. Every building society in the UK is a member of theBuilding Societies Association (Wikipedia, 2008).

3. In 2002, Halifax was acquired by Bank of Scotland (BOS) to become HBOS, a decision thatcontributed to bringing it to the verge of collapse, leaving it to be rescued by Lloyds TSB(Jamieson, 2008). Abbey National was sold to Santander in 2004 and Alliance and Leicesteracquired by the same Spanish bank in 2008. The Woolwich was bought by Barclays in 2000.

4. Established banks wanted a ready-made piece of this profitable action, which accounts fortheir interest in acquiring converted banks.

5. Demutualisation is the process by which building societies and mutual insurers convertthemselves from mutual organisations (owned by their members/customers) toprofit-making companies which distribute profits to their shareholders (Finance Glossary,2008).

6. Collateralised debt obligations, or CDOs, are sophisticated financial tools that repackageindividual loans into a product that can be sold on the secondary market. These packagesconsist of auto loans, credit card debt, or corporate debt. They are called collateralisedbecause they have some type of collateral behind them. CDOs are called asset-backedcommercial paper if the package consists of corporate debt, and mortgage-backed securitiesif the loans are mortgages. If the mortgages are made to those with a less than prime CMBs(see below) credit history, they are called sub-prime mortgages (About.com, 2008).

7. A credit default swap (CDS) is a specific kind of counterparty agreement which allows thetransfer of third party credit risk from one party to the other. One party in the swap is alender and faces credit risk from a third party, and the counterparty in the credit defaultswap agrees to insure this risk in exchange of regular periodic payments (essentially aninsurance premium). If the third party defaults, the party providing insurance will have topurchase from the insured party the defaulted asset. In turn, the insurer pays the insured theremaining interest on the debt, as well as the principal (Investor Words, 2008).

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8. Access to the wholesale market was facilitated by the 1986 Building Societies Act, whichenabled societies to demutualise, thereby allowing greater leverage, unrestrictedsecuritisation and access to new types of investors (e.g. institutional investors). Buildingsocieties retaining their mutual status have remained bound by comparatively tighterrestrictions which make them predominantly reliant upon a more reliable but less financiallyrewarding flow of retail deposits.

9. The conversion of Bradford & Bingley, which was the only building society to convertagainst managerial advice, was blamed by managers on the actions of carpetbaggers (seeHeffernan, 2005).

10. The directors foiled the first demutualisation attempt butsuccumbed to the second attemptled by a plumber who successfully forced the vote in 1999 when the line taken by thedirectors was that they did not want to impinge on democracy (Ashton and Dey, 2008).

11. For example, as a consequence of this assessment, Fitch downgraded Principality to A 2from A for exposures to second charge loans or loans secured on the borrower’s home, whichit anticipated would result in increased defaults but also in more severe losses thanpreviously expected. West Bromwich was also downgraded to A 2 in recognition of itsrapid growth in buy-to-let and commercial lending.

12. Not that the mutuals have been entirely immune to the lure of risky loans, especially in thecommercial sector. Notably, as a consequence of “impairment charges in relation tocommercial and specialist lending due to the deteriorating property market” (CheshireBuilding Society Merger with Nationwide Building Society, Merger Notofication StementRequired by Schedule 8A to the Building Societies Act 1986, paragraph 1), the Cheshire andalso the Derbyshire Building Society have merged with the largest UK mutual, theNationwide. Smaller societies are relatively undercapitalised, so that when house prices fall,arrears increase, or frauds come to light as house prices fall, and depositors turn to bigger,more secure institutions, they struggle to survive. In the case of the Barnsley BuildingSociety, its takeover by Yorkshire Building Society was precipitated by its holding of £10min collapsed Icelandic banks.

13. A mortgage-backed security (MBS) is a type of asset-backed security that is secured by amortgage or collection of mortgages. These securities must be grouped in one of the top tworatings as determined by an accredited credit rating agency, and usually pay periodicpayments that are similar to coupon payments. Furthermore, the mortgage must haveoriginated from a regulated and authorised financial institution (Investopedia, 2008).

14. Other societies opted for a more diversified strategy in which they tried to sell a range offinancial and related services to their base of account holders. Bradford & Bingley initiallytook this route but its attempts to diversify (e.g. acquisition of a large chain of estate agents)was ill-fated and it drew back from such ventures in order to concentrate on mortgagelending, with a specialisation in the buy-to-let segment.

15. The HBOS stock price has continued to plummet, so making the intended rescue by LloydsTSB more precarious without the downward renegotiation of the initial offer price.

16. In stark contrast, the Nationwide, largest of the mutual societies, decided to rein back on itslending during this period, which reduced from £5.6bn in 2007 to £3.3bn as their “rivalswere driving down pricing, loosening affordability constraints and sacrificing quality formarket share“ (Stuart Bernau, Retail Director, Nationwide; quoted in Prosser, 2007).

17. At the end of 1997, it held £15.8bn worth of assets. At the end of 2006 it had £101bn worth ofassets on its consolidated balance sheet, containing mainly secured lending on residentialproperty (House of Commons Treasury Select Committee, 2008a).

18. LIBOR is incorrectly referred to as “London Interbank Overnight Rate” here instead of“Offered Rate”. Maturities of inter-bank deposit rates range from overnight to a year.

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19. This had been reduced during the year from around 60 per cent by increasing the inflow ofretail deposits.

20. Mervyn King, Governor of the Bank of England, said shortly after the bail-out of NorthernRock that rescuing institutions that have taken on too much risk would involve “moralhazard”, thus encouraging even more excessive risk taking at a later point (quoted in Davies,2007). (It was only on 19 September that the Bank took the decision to inject £10m into themoney markets to reduce the cost of inter-bank lending.)

21. Mortgage Express is celebrated in a UK Department of Industry case study on quality andexcellence, where its strategy is noted as “provid[ing] market leading products in suchsegments and Let & Buy, Buy-to-Let, Negative Equity, 100% and Self-Employed, deliveredwith a first class service“ (Business Balls, 2008).

22. The mortgages that are particularly troubling for Bradford & Bingley are those acquired byother lenders. Comprising mostly mortgages bought from GMAC-RFC, a UK offshoot of GM,with which it had struck a £12bn deal, Bradford & Bingley’s troubling acquired mortgageswere up to 5.11 per cent in September 2008 (Pollock, 2008b).

23. In February 2008, four months prior to the announcement of the rights issue in May,Standard & Poor had rated Bradford & Bingley A-1, but with a qualification that “B&B’sliquidity position, although sound, was not as strong as we expected after the salee ofvarious loan books” (Money Marketing, 2008). In its explanation of why it had downgradedBradford & Bingley’s credit rating, Moody’s noted that the company was contracted toacquire up to £350m of mortgages a quarter from GMA and that this did not bode well forfunding costs: “These mortgages have displayed a significantly faster deterioration of assetquality than the own-originated loan portfolio of Bradford & Bingley“ (Moody’s; quoted inKennedy, 2008).

24. But the report did also warn that the market for securitisation was likely to close (Hill, 2007).With the markets dry, Bradford & Bingley was indeed unable to complete and securitisationin order to raise much needed funding.

25. Notably, the insurance company AIG’s exposure to CDSs contributed to its collapse andnationalisation.

26. In December 2007, the FSA found building societies were well above that level or their owntargets (see House of Commons Treasury Select Committee, 2008a).

27. The “Square Mile” refers to the City or financial sector in the UK or, more generally, toinstitutional shareholders.

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Ferreira-Marques, C. (2008), “Fitch warns on outlook for UK mutual lenders”, available at: www.reuters.com/article/rbssBanks/idUSL2299083120080722 (accessed 30 October 2008).

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Fletcher, N. (2007), “Shining knight of Wall Street lifts the gloom”, available at: www.guardian.co.uk/business/2007/jun/30/marketforces (accessed 31 October 2008).

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Gill, S. (1995), “Globalization, market civilization, and disciplinary neo-liberalism”, Millennium:Journal of International Studies, Vol. 24 No. 3, pp. 399-423.

Goodway, N. (2007), “Northern Rock profit warning hits shares”, available at: www.thisismoney.co.uk/investing-and-markets/article.html?in_article_id ¼ 421767&in_page_id ¼ 3(accessed 31 October 2008).

Griffiths, K. (2001), “The Monday Interview: The consumer’s champion seeks his nextbattleground”, available at: www.independent.co.uk/news/business/comment/the-monday–interview-the-consumers-champion-seeks-his-next-battleground-752992.html(accessed 30 October 2008).

Harvery, D. (2007), A Brief History of Neo-Liberalism, Oxford University Press, Oxford.

HBOS (2006), “The way we do business”, available at: www.hbosplc.com/community/includes/Bank_of_Scotland_CR_Report.pdf (accessed 27 October 2008).

Heffernan, S. (2005), “The effect of UK building society conversion on pricing behaviour”, Journalof Banking and Finance, Vol. 29 No. 3, pp. 779-97.

Hill, N. (2007), “What are the implications of Northern Rock’s bail out for the other UK banks?”,available at: www2.standardandpoors.com/portal/site/sp/en/us/page.article/4,5,5,1,1148447595738.html )accessed 31 October 2008).

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House of Commons Treasury Select Committee (2008b), “The run on the Rock”, 5th Report onSession 2007-08: Volume II, Written and Oral Evidence, January 24.

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Jamieson, B. (2008), “Darkest day for Scottish banking as the Bank of Scotland faces its end”,available at: http://news.scotsman.com/latestnews/-Darkest-day-for-Scottish.4503252.jp(accessed 28 October 2008).

Kennedy, S. (2008), “Bradford & Bingley shares slide after TPG backs out”, available at: www.marketwatch.com/news/story/bradford–bingley-shares-drop/story.aspx?guid ¼ %7BB7F3BC1C-94CA-4931-B3A9-FB12184FF5C0%7D (accessed 31 October 2008).

Langley, P. (2006), “Securitizing suburbia: the transformation of Anglo-American mortgagefinance”, Competition and Change, Vol. 10 No. 3, pp. 283-99.

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Montgomery, J. (2006), “The financialization of the American credit card industry”, Competitionand Change, Vol. 10 No. 3, pp. 301-19.

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Murden, T. (2008), “Business comment – only merger will keep HBOS in the game wherenationalist card counts for nothing”, available at: http://scotlandonsunday.scotsman.com/business/Business-Comment–Only-merger.4606586.jp (accessed 29 October 2008).

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Further reading

Aalbers, M.B. (2008), “The financialization of home and the mortagage market crisis”,Competition and Change, Vol. 12 No. 2, pp. 148-66.

Cook, J., Deakin, S. and Hughes, A. (2002), “Mutuality and corporate governance: the evolution ofUK building societies following deregulation”, Journal of Corporate Law Studies, Vol. 2,pp. 110-38.

Hildyard, N. (2008), “A (crumbling) wall of money: financial bricolage, derivatives and power”,available at: www.thecornerhouse.org.uk/pdf/document/WallMoneyOct08.pdf (accessed18 December 2008).

Munro, M. (2005), “Need a loan for any purpose? Sub prime lending in the UK”, ENHRConference, Iceland, available at: www.borg.hi.is/enhr2005iceland/ppr/Munro.pdf

Pryke, M. and Freeman, T. (1994), “Mortgage-backed securitization in the United Kingdom:the background”, Housing Policy Debate, Vol. 5 No. 3, pp. 307-42.

Tayler, G. (2003), “UK building society demutualisation motives”, Business Ethics: A EuropeanReview, Vol. 12 No. 4, pp. 394-402.

About the authorsRobin Klimecki studied for a first degree in Sociology at the University of Mainz, Germany,before taking a Master’s in Organization Studies at the University of Warwick, UK. He iscurrently a PhD candidate at Cardiff Business School, University of Cardiff, UK undertaking astudy of building societies in the context of the lead up to the financial crisis of 2007/2008.

Hugh Willmott is Research Professor in Organization Studies, Cardiff Business School. Hehas a long-term interest in the study of financial services, having undertaken an intensive,longitudinal case study of a mutual insurance company (with David Knights) and a number ofstudies of the accounting industry (with Prem Sikka and David Cooper). He has served on theeditorial boards of Accounting, Organizations and Society, Critical Perspectives on Accountingand Accounting, Auditing and Accountability Journal, and he currently serves on the boards ofAcademy of Management Review, Organization Studies, Journal of Management Studies andOrganization. Hugh Willmott is the corresponding author and can be contacted at:[email protected]

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Building resilience tointernational financial crises:

lessons from BrazilAndre Filipe Zago de Azevedo

Universidade do Vale do Rio dos Sinos (UNISINOS), Sao Leopoldo, Brazil, and

Paulo Renato Soares TerraSchool of Management, Universidade Federal do Rio Grande do Sul (UFRGS),

Porto Alegre, Brazil

Abstract

Purpose – This paper sets out to argue that, due to a stable set of economic policies over the pastdecade, today Brazil is much more resilient to international financial crises than in the 1990s.

Design/methodology/approach – The paper presents preliminary macroeconomic data in acountry case study.

Findings – The paper concludes that the initial impact of the current international financial crisis onBrazil has been much less severe than similar crisis episodes in the past.

Research limitations/implications – Given that the crisis is still unfolding, the paper presentsonly preliminary data regarding its impact on emerging markets.

Practical implications – The paper suggests that emerging markets should adopt flexibleexchange rate regimes and stable macroeconomic policies as a means to reduce their exposure tointernational shocks.

Originality/value – The paper makes an initial diagnosis regarding the impact of the internationalfinancial crisis on emerging markets that have adopted sensible economic policies, and is of interest toscholars, business people, and policymakers in developed and emerging countries.

Keywords International finance, Financial markets, Emerging markets, Brazil


1. IntroductionSome analysts point out that the current financial crisis may be the most serious sincethe Great Depression of the early 1930s – or even more serious than that. Others arguethat it should be at least deeper than those which occurred in the 1990s. Although it istoo early to assess its full impact on the economy, it has resemblances to previouscrises. First, like the 1929 crisis, it had its epicenter in developed countries. Second, it issystemic, since the initial turmoil was transmitted to many markets and virtually allcountries[1]. Shortly after its onset, the ongoing financial crisis has tumbled stockmarkets across the world and dumped other currencies against the US dollar, asinvestors reduce the riskiness of their portfolios and “flee to quality”, with moneymoving towards US assets, in particular Treasury bonds. Soon after, credit marketsbecame blocked as banks and financial institutions were unwilling to lend to oneanother due to the risk of default. Following these short-run events, the crisis maydamage the real economy, reducing the pace of economic growth in both developed anddeveloping countries.



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Vol. 5 No. 1/2, 2009pp. 141-156


DOI 10.1108/17422040910938758

This paper aims to describe these recent effects on emerging markets, withemphasis on the Brazilian economy, comparing the evolution of these indicators in thiscrisis with the Mexican and Asian crises of the 1990s. In our view, the impact of thecurrent financial crisis on the real Brazilian economy is likely to be much less severethan during the 1990s financial crises. There are two major reasons that explain thisresilience:

(1) the flexible exchange rate regime; and

(2) the adoption and, perhaps more importantly, the maintenance and improvementof the same set of economic policies for over a decade.

The current floating exchange rates will absorb most of the shock waves caused by thecrisis and channeled into the Brazilian economy though its external financial and tradelinkages. Moreover, Brazilian external sustainability has been improving throughoutthe years due to a set of policies including higher diversification of markets for exportsand increased external solvency.

The remainder of the paper is divided into three sections. Section 2 presents a briefsummary of the theories and empirical regularities of financial crisis. Section 3analyses the short- and medium-term impacts of the current financial crisis withemphasis on the Brazilian economy, comparing this crisis with those that occurredduring the 1990s. The last section offers some concluding remarks.

2. Theories and empirical regularities of financial crisesFinancial crises are not all created equal: there are at least three different types offinancial crisis. The first type is the banking crisis, in which a run of depositors on thebanking system leads to a systemic liquidity failure. The second type is thebalance-of-payment crisis[2], in which a run on a country’s reserves leads to suddendepreciation of the national currency or foreign debt default. The third type is the assetprice crisis, in which inflated asset prices (the “bubble”) are reassessed by investors,causing a run on those assets. Each type of crisis is summarized below.

2.1 Banking crisesBanking crises are a fairly common event in economic history[3]. In particular, crises indeveloping (mainly transition and emerging) economies have become an importanttopic in the research agenda of both academic and policymaking milieus. This is notonly because such crises cause severe real economic costs and hinder development inthe affected countries, but also because financial crises have become more frequent anddisseminated as international financial markets become more integrated.

Because one of the main functions of the banking firm is liquidity transformation,they are naturally vulnerable to generalised withdrawals by depositors. Diamond andDybvig (1983) presented a theoretical framework for banking crises as a result ofasymmetric information. If depositors’ expectations are that a bank may becomeinsolvent, then as they rush to be the first in line to withdraw their funds, the bank willbecome illiquid. Moreover, if depositors interpret the run on a given bank as a signalthat the whole banking system is illiquid, then a systemic banking crisis may result assound and unsound banks cannot be discriminated. Eichengreen et al. (1998) point outother possible channels for banking crises, such as balance-of-payment crises[4] and

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moral hazard stemming from guarantees such as implicit government guarantees anddeposit insurance schemes.

2.2 Balance-of-payment crisesBalance-of-payment crises are characterized by a run on a country’s reserves. Suchepisodes have been extensively studied in the literature. Although the literature refersto different theoretical models of crisis as different “generations”, we prefer to followthe simpler classification given by Eichengreen et al. (1998), who distinguishedbetween crises caused by inconsistent policies and crises occurring in the presence ofconsistent policies[5]:

. Balance-of-payment crises under inconsistent policies – In such models,balance-of-payment crises arise from the government objective of sustaining afixed exchange rate while pursuing expansionary monetary policy. Free capitalmobility will offset any attempt to set interest rates differently from internationallevels. If the government tries to pursue an independent monetary policy, thenthe exchange rate will be under pressure. Attempts to sustain the exchange ratewill run down international reserves till the point in which the government isforced to devalue. Krugman (1979) and Flood and Garber (1984) present theseminal work on this type of crisis.

. Balance-of-payment crises under consistent policies – The empirical observationthat even economies with sound policies have been subject tobalance-of-payment crises lead to the development of alternative models toexplain such phenomena. Multiple equilibria models predict that if sustainingthe parity is costly even for a well-behaved government, then there might existan adverse equilibrium in which the optimal response of speculators is to betagainst the currency and the crisis becomes self-fulfilling. Obstfeld (1986)proposes such dynamics formally. Other types of crises under consistent policiesrely mostly on information asymmetry effects such as moral hazard and adverseselection[6].

The balance-of-payment crisis literature is rich and, as noted by Rodrik (1998), everynew crisis in the past 20 years has spawned a whole new generation of economicmodels explaining the crisis that has just happened – but unable to explain or predictthe next one. His conclusions are that if we are forced to look for a new series of policyerrors each time a crisis hits, we should be extremely cautious about our ability toprescribe a policy regime that will sustain a stable system of capital flows.

2.3 Asset price crisesAn empirical observation is that financial crises often follow a period in which assetprices rise sharply and then collapse, and one may classify such crises as asset pricecrises[7]. Allen and Gale (2000) describe such crises as having three distinct phases:

(1) Inflating the bubble – The first phase is characterized by a rapid expansion incredit, which may result from a policy shift from the central bank or a structuralchange such as financial liberalization. The increased liquidity is accompaniedby an increase in assets that are in fixed supply in the short-run, typicallystocks and property. The price of such assets is bid up in a spiral that cancontinue for some time, inflating the bubble.


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(2) Bursting the bubble – The second phase is characterized by an exogenous eventthat precipitates the bursting of the price bubble. It can be a change in the realeconomic environment such as the price of an international commodity like oilor a slump in real activity. Also, the trigger can be a shift in lender sentimentregarding the interest rate and the level of credit available in the financialsystem. Alternatively, changes in the political balance of power or social unrestcan cause a change in investor expectations that fires an asset sell-off.

(3) Ensuing financial crisis – The final phase is characterized by generalizeddefault. Many debtors that have borrowed to buy assets at inflated pricescannot honor their obligations, compromising the soundness of the bankingsector. Depending on the severity of the default, a systemic banking failureand/or a balance-of-payment crisis may follow, and the real sector of theeconomy is affected.

Several theoretical studies have been proposed to explain bubbles. Although someapproach their existence as a result of irrationality (e.g. De Long et al., 1990), a numberof authors have explained bubbles as an outcome of rational behavior (e.g. Blanchardand Watson, 1982), given some market imperfection like asymmetric information.

Allen and Gale (2000) propose a model in which bubbles and the ensuing financialcrises are the result of the risk shifting problem between lenders and borrowers. Intheir setting, it is not simply the level of credit that is important in bursting the bubble,but also the uncertainty of its future levels. Two points of their analysis areparticularly remarkable:

(1) financial liberalization often becomes a major factor leading to suchuncertainty; and

(2) banking and balance-of-payment crises are often triggered by the asset pricecrisis.

We discuss the interdependence among these three types of crises next.

2.4 “Twin” and “triplet” crisesIn the recent experience of international finance, many countries that have experienceda balance-of-payment crisis have also had a domestic banking crisis around the sametime. This empirical regularity raised the question of the extent to which the two arelinked together, hence the term “twin crises”. While theoretical and empirical work onthe causes of each type of crisis generated a prolific literature[8], their interaction hasbeen subject of less attention. In a well-known paper, Kaminsky and Reinhart (1999)draw from this literature three hypotheses concerning the chain of causation betweenthese events:

(1) Balance-of-payment crises cause banking crises – Because the governmentcommitment to some nominal standard (i.e. the exchange rate) makes thefinancial sector magnify real shocks to the economy. This is so because the lossof international reserves that follows the attempt of the government to defendthe currency result in a credit crunch that gives rise to increased bankruptcy inthe private sector, rendering banks with a stock of non-performing loans and afull-fledged banking crisis ensues.

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(2) Banking crises cause balance-of-payment crises – Because as the central bankintervenes in the banking sector to bail out troubled financial institutions, itsability to sustain the exchange rate commitment erodes. If the central bankfinances the bailout by printing money, the standard first-generation model ofcrisis result (Krugman, 1979); if instead the central bank finances it by issuingdebt, the expectation of future monetization may make the crisis self-fulfilling(Obstfeld, 1986).

(3) Common factors[9] cause both balance-of-payment and banking crises – Thereis no reason to expect one type of crisis to anticipate the other. Since thefundamental problems are created at the same time, which crisis erupts first is ajust matter of circumstance. For instance, foreign exchange rate-basedstabilization plans embody the commitment of the government in sustainingsome parity that restricts the role of the central bank as a lender of last resort forthe domestic financial sector. At the same time, the government commitmentserves as an implicit (or even explicit) guarantee that discourages borrowers tohedge their foreign currency exposure. When either type of crises erupts, ittriggers the other.

In their empirical investigation, Kaminsky and Reinhart (1999) indeed find thatbanking crises help in predicting balance-of-payment crises, but the converse is nottrue. However, financial liberalization helps in predicting banking crises so that ratherthan a causal relationship from banking to balance-of-payment crises, the evidencesuggests instead that common causes characterize these events[10]. Eichengreen et al.(1998) survey the literature on the causal relationship between financial liberalizationand the various types of crises and conclude that there is no definite empirical evidencethat freer capital flows cause crises, although the vulnerability to previous systemicdeficiencies seem to be amplified.

2.5 Economic indicators and financial crisesThe real effects of financial crises may be felt in a wide range of economic indicators.However, many studies in the causes and consequences of crises have narrowed thenumber of relevant economic indicators to a relatively small number. Although theconsistency of such indicators across different types of crises is questionable,especially in terms of their predictive ability (see International Monetary Fund, 1998,chapter IV), such indicators do illustrate the consequences of financial crises in asummarized fashion. A number of papers have embraced such task (e.g. Sachs et al.,1996; Gavin and Hausmann, 1996; Kaminsky, 1998; Eichengreen, 1999; Eichengreenand Rose, 2004, among others).

In the short term, financial crises are characterized by sudden drops in the stockmarket, reflecting the change in economic agents’ sentiment regarding the futureprospects of the afflicted economy. Risky financial assets in general lose value at theonset of a crisis, or even shortly before it, as investors reassess their expectations inlight of new information or a specific triggering event[11].

Moreover, the domestic currency also loses value as international investors’ riskaversion increases during crises episodes, prompting them to rebalance their portfoliostowards less risky assets, usually developed countries’ government bonds. In afinancially integrated environment, such flight to quality causes a fire sale of domestic


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assets and increased demand for foreign currencies, usually the US dollar. Such a chainof events translates into a depreciation of the domestic currency in a flexible exchangerate regime, and intervention of the central bank in a more rigid exchange rate regime.Central bank intervention takes the form of sales of reserves in order to defend thedomestic currency – which erodes the country’s foreign reserves – and/or sharpincreases in the interest rates – which reduces real activity in the medium term.

In the medium term, the consequences of financial crises are felt in a reduction inreal activity, either by the aforementioned rise in interest rates or by a reduction in theavailability of private credit due to the flight to quality of domestic investors andsystemic fears of bankruptcy in the banking system.

3. Case study: Brazil and the current international financial crisisBrazil has been hit by various international financial crises in the past decades[12].Two of the most serious were the Mexican crisis (also known as the “Tequila Crisis”) of1994-1995 and the Asian crisis (also known as the “Asian Flu”) of 1997. In this section,we compare some economic indicators around the onset of such crises with the currentinternational crisis.

3.1 Short-term evidenceAs usually occurs after the beginning of a financial crisis, stock markets tumbledaround the world since last September, when the current international crisis spread intwo directions:

(1) across the Atlantic to Europe and Asia; and

(2) from the financial markets into the real economy[13].

Initially, the stock market plunge could still be associated with worries about thehealth of large banks, after a warning that more credit-crunch related losses could lieahead, reflecting that the crisis in the subprime mortgage lending market was leadingto a more generalized credit crisis. During September, although generalized, the declinein stock markets was not so impressive, with losses in most markets not exceeding 10percent (Table I). In October, however, in all major developed and developing countriesstocks declined more significantly, as the continuous drop in stock markets across theglobe also reflected dreadful economic figures, as a recession in the developed worldand an economic slowdown in developing countries seemed inevitable, loweringexpected profits in 2009. As a result, from early September to the end of October stockmarkets in Russia, Argentina and Turkey, for example, fell by more than 35percent[14]. In developed countries the drop ranged from 26 percent in the USA to 31.6percent in Japan.

Comparing the effect in the stock market in Brazil of the current crisis with thosethat happen during the 1990s, one can see that the recent plunge in the stock markettwo months after its onset is not unprecedented. Although Brazil is one of the countriesthat suffered most from the subprime crisis regarding the decline in stocks, during thesame period after the Mexican crisis they plunged even more, reaching 38 percent(Table II). So far, one would expect the main channel through which the likely fall incapital inflows would impact Brazil to be via the stock market. Although aboutone-third of Brazilian shares are foreign-owned, most are still domestically held, and

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consequently there will be a reduction in consumption and investment due to thewealth effect and the increased cost of capital, respectively.

With regard to exchange rates, the intense demand for US assets caused a sharpappreciation of the US dollar in relation to most currencies. During the 12 months toOctober 2008, it is possible to note two different phases. From October 2007 toSeptember 2008, there was a mixed picture, with some currencies showing anappreciation and others a depreciation against the US dollar. The Brazilian real, forexample, registered an appreciation of about 7 percent in this period (Table III). Thesame phenomenon occurred with other developing countries’ currencies, for example inArgentina, Mexico and Venezuela. However, the situation changed dramatically inOctober, when most currencies experienced a sharp decline against the US dollar. Thistrend was more intense in relation to some currencies, including the Brazilian real,which showed the largest depreciation, 42 percent in that month, turning a smallappreciation into a depreciation of 32 percent in the last 12 months.

This recent trend in exchange rate markets occurred as the financial crisisbroadened and intensified, reflecting a short-run “flight to quality” movement, usual in

Country One-month change (%)

Russia 225.2 258.1Argentina 28.7 246.5Turkey 210.6 236.5Brazil 27.0 234.5India 213.3 232.4Indonesia 213.4 231.9Japan 210.4 231.6Canada 210.8 229.7Mexico 25.1 229.0Euro zone 210.0 228.5Thailand 28.5 228.4USA 26.1 226.1South Korea 20.9 220.5China 20.8 216.7Chile 23.8 215.2Venezuela 27.0 210.7

Source: The Economist (2008)

Table I.Stock market changesfollowing the current

subprime crisis

Mexican crisis Asian crisis Subprime crisis

Period

One-monthchange

(%)

Two-monthchange

(%)

One-monthchange

(%)

Two-monthchange

(%)

One-monthchange

(%)

Two-monthchange

(%)

Brazilian Bovespa 219.5 238.3 29.4 216.6 27.0 234.5

Source: IPEADATA (available at: www.ipeadata.gov.br/ipeaweb.dll/ipeadata?SessionID=1047073417&Tick=1226614506234&VAR_FUNCAO=RedirecionaFrameConteudo%28%22iframe_dados_m.htm%22%29& Mod=M)

Table II.Stock market changes


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periods of economic uncertainty, as described in the previous section. Whether thissituation is to be maintained remains to be seen, but its effects on the real economy arelikely to be quite different from the 1990s crises in Brazil. As the next section will show,during that period Brazil adopted a pegged exchange rate regime (during both theMexican and Asian crises), so when the crisis began the government was forced todefend its currency by reducing foreign reserves and “dramatically” increasing interestrates, slowing down the economy[15]. Given the current floating exchange rate regimein Brazil, the sharp depreciation of the real against the US dollar will not cause such asurge in interest rates as occurred in the 1990s.

3.2 Medium-term expectationsOne of the most likely effects of the ongoing financial crisis is the reduction ofeconomic growth prospects in the medium term. As mentioned earlier in this paper,financial crises contract economic activity, either through rising interest rates or byreducing the availability of private credit due to the flight to quality and systemic fearsof bankruptcy. By reducing credit, the current international crisis should lead to adecrease in investment and consumption, notably in 2009. Growth expectations for2008-2009 have already deteriorated dramatically in the last months. Most developedand emergent economies will grow less in 2009 than they did in 2007 (Table IV). Whilemost developed countries, including the USA, The European Union and Japan, shouldexperience a recession in 2009, some emerging economies will only experience aslowing down in economic growth. In some emerging countries, however, the expectedabsolute decrease in growth is significant in the period 2007-2009, especially in

Country

October 2007-September 2008

(%)

September 2008-October 2008

(%)

October 2007-October 2008

(%)

South Korea 225.44 221.41 252.29Brazil 17.22 242.51 232.22Chile 24.02 219.34 224.14India 2 12.98 28.11 222.14Mexico þ3.70 225.00 220.37Turkey 21.68 216.53 218.49UK 214.29 23.57 218.37Canada 28.16 25.66 214.29Venezuela þ7.80 219.23 29.93Indonesia 21.45 24.27 25.79Russia 21.20 23.57 24.82Euro zone þ2.82 25.80 22.82Argentina 3.48 25.57 21.90Thailand 20.29 þ0.87 þ0.58China þ8.92 þ0.29 þ9.19Japan þ7.69 þ7.41 þ14.53

Notes: Exchange rate appreciation against the US dollar: + sign; exchange rate depreciation againstthe US dollar: 2 signSource: The Economist (2008)

Table III.Exchange rate changesagainst the US dollar

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Venezuela (24.9 percentage points), Argentina (24.8 percentage points) and China(23 percentage points).

Although the crisis provoked an increase in the uncertainty about the impact onBrazilian growth, it is expected to reach 3.4 percent in 2009, two percentage points lessthan in 2007, most of this effect coming from the expected credit crunch. It is worthnoting that the expansion of credit in Brazil has played a key role in increasingconsumption since 2006. The total credit operations (from public and private sectors)reached 38 percent of the country’s gross domestic product (or R$ 1.1 trillion) in August2008, well above the 32 percent observed one year earlier (Figure 1). Besides soaringcredit, consumption has also been stimulated by falling unemployment, the increasingincome of the workforce and interest rates being maintained at a relatively low level byBrazilian standards. This situation has allowed millions of Brazilians access toconsumer goods, like cars, computers and TV sets, which they were unable to purchaseuntil recently. However, the continuous increase in the base interest rate from 11.25percent to 13.75 percent from April to September 2008 and the effects of theinternational crisis should change this scenario in the next months, reducing GDPgrowth prospects for 2009.

The preceding analysis showed that the current crisis should harm the Brazilianreal economy less when compared with the developed world. In the case of Brazil, itsexternal sustainability has been improving throughout the years, as a result of manyfactors, including higher diversification of markets for exports, increased externalsolvency and the adoption of a floating exchange rate regime. The process ofdiversification of markets for Brazilian exports has been pursued intensively since2002. In that year, 62 percent of Brazilian exports were destined for developedcountries, while the remaining 38 percent were sent to developing countries (Figure 2).In 2007, however, developing countries were responsible for purchasing half ofBrazilian exports. As the financial crisis is prone to affect developed countries more

Country2007(%)

2008(%)a

2009(%)a

2009/2007 change(%)

Venezuela 7.9 5.2 3.0 4.9Argentina 8.3 6.0 3.5 4.8China 11.5 9.8 8.5 3.0Brazil 5.4 5.2 3.4 2.0Euro zone 5.4 1.2 0.6 2.0Chile 2.6 3.6 3.6 1.8USA 2.1 1.6 0.6 1.5Japan 1.9 0.7 0.6 1.3India 7.9 7.7 7.1 0.8South Korea 5.0 4.4 4.2 0.8Indonesia 6.2 5.8 5.5 0.7Turkey 4.9 4.5 4.3 0.6Russia 7.2 7.5 6.8 0.4Malaysia 6.0 6.0 5.6 0.4Canada 1.7 0.8 1.4 0.3

Notes: aPredicted valuesSource: The Economist (2008)

Table IV.GDP growth in selected

countries


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heavily, the increasing penetration of the country’s exports in the developing world islikely to limit the impact of the financial crisis on Brazilian exports. Moreover, therecent depreciation of the national currency against the US dollar may offset the sharpdrop in commodities prices, most of them exported by Brazil.

Besides the higher diversification of markets for exports, many indicators show anincrease in Brazilian external solvency compared with the past. The total external debt

Figure 1.Brazilian total creditoperations (percentage ofGDP)

Figure 2.Brazilian exportdestination countries(percent)

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as a ratio of GDP, for example, declined from 41.2 percent in 2002 to 14.7 percent in2007 (it is expected to decline further to 14 percent in 2008). This, alongside the recentincrease in foreign reserves to above $US200 billion, allowed the total net external debtas a ratio to GDP became negative (20.9 percent) in 2007 (Figure 3). The improvementin these indicators was fundamental to allow Brazil to receive the investment grade bytwo independent credit rating agencies in early 2008. Furthermore, net foreign direct

Figure 4.Foreign direct

investment £ currentaccount ($US, billions)

Figure 3.Brazilian total external

debt (percentage of GDP)


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investment (FDI) is expected to reach $US35 billion in 2008, limiting the potentialdamage caused by the increasing current account deficit in this period (Figure 4).

Finally, the current floating exchange rate regime adopted in Brazil, by reducing theeffects of external crises on output, is another advantage compared with the peggedexchange rate regime implemented after the real stabilization plan in the second half ofthe 1990s[16]. Floating exchange rates allows the necessary adjustments via changes inthe exchange rates instead of reducing foreign reserves and/or increasing interest ratesas occurs with fixed or pegged exchange rate regimes. During both the Mexican andAsian crises, there was a significant increase in base interest rates in Brazil (SELICrate[17]) in order to minimize foreign funds flowing out. Already sky-high interest rateswere raised by seven percentage points to 57 percent in the aftermath of the Mexicancrisis in 1995 and by an astonishing 19.5 percentage points to 40 percent following theAsian crises in 1997 (Table V). Obviously, those measures greatly slowed down GDPgrowth when they were implemented. In 1998, for example, while world GDP growthreached 2.8 percent, the Brazilian economy was stagnant (with GDP growth of only 0.1percent).

Therefore, given the points mentioned above, although the Brazilian economy hasalready been affected by the current financial crisis, through stock markets, exchangerates and credit, it seems likely that this crisis will have a much more limited impact onBrazil’s real economy than those of the 1990s.

4. Discussion and synthesisWe have argued that the real consequences of the current international financial crisisin Brazil should be substantially less severe than previous crises, despite the largermagnitude of the present crisis. Why is Brazil more resilient to these episodes todaythan it was in the past?

In our opinion, there are two major reasons that explain such resilience:

(1) the flexible exchange rate regime; and

(2) the adoption and, perhaps more importantly, the maintenance and improvementof the same set of economic policies for over a decade.

The floating exchange rates, as illustrated above, absorbs most of the shock wavescaused by the crisis and channeled into the Brazilian economy through its externalfinancial and trade linkages. Thus, the impact of the current financial crisis on theBrazilian real economy is likely to be much less severe than during the 1990s financialcrises.

Crisis Mexican crisis Asian crisisperiod Before After Before After

Interest rate (%) 50 57 20.5 40Change (%) 7 19.5

Source: IPEADATA (available at: www.ipeadata.gov.br/ipeaweb.dll/ipeadata?SessionID=1047073417&Tick=1226614506234&VAR_FUNCAO=RedirecionaFrameConteudo%28%22iframe_dados_ m.htm%22%29&Mod=M)

Table V.Interest rates in Brazilbefore and after the 1990scrises (annual rate)

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Regarding the set of economic policies, president Luıs Inacio Lula da Silva’sgovernment, now in its second term in office, maintained the guidelines of the economicpolicy unchanged, despite sharp ideological discordances with his predecessor, formerpresident Fernando Henrique Cardoso. In particular, president da Silva kept thefloating exchange rate regime, prioritized the federal fiscal balance orthodoxy,preserved the operational independence of the central bank in setting monetary policyunder an inflation-targeting regime, and stimulated the internationalization of theeconomy through the expansion and diversification of international trade – inparticular the “South-South” trade initiative – and multinationalization of Braziliancompanies. Also of particular importance in this context, we underscore the approvalof Complementary Act 101 in 2000 (Brazil, 2000), legislation that established limits tothe fiscal discretion of the three levels of government (federal, state and municipal).

Considering the two terms that president Fernando Henrique Cardoso stayed inoffice from 1995 to 2002, at the end of the current term in 2010, Brazil will be under thesame set of major economic policy guidelines for longer than any other period underdemocratic governments in its recent history. A positive effect of such stable set ofpolicies – in conjunction with the favorable international economic environmentduring 2002-2007 – is the reduction of financial fragilities that had plagued the countryin other periods of international financial turbulence.

Therefore, given the points mentioned above, although the Brazilian economy hasalready been affected by the current financial crisis, through stock markets, exchangerates and credit, it sounds likely that the crisis will have a much more limited impact onBrazil’s real economy than those of the 1990s. The Brazilian experience may thus serveas a lesson to other developing countries that wish to overcome their financial fragilityin an era of freer capital flows: adopt a clear, sound, and stable set of economic policiesover the long term.

Notes

1. The International Monetary Fund (1998) defines systemic financial crises as potentiallysevere disruptions of financial markets that, by impairing markets’ ability to functioneffectively, can have large adverse effects on the real economy.

2. The International Monetary Fund (1998) distinguishes between a currency crisis(devaluation or sharp depreciation of the currency) and a foreign debt crisis (default inthe service of foreign debt). However, we follow the literature and adopt the more generalterm balance-of-payment crisis that encompasses both (sub)types of crisis.

3. For a more complete discussion of the causes of banking crises, please refer to Goldstein andTurner (1996) and Honohan (2000).

4. More on the relationship between banking and balance-of-payment crises can be found insection 2.4.

5. The first type of crisis corresponds to first-generation models of balance-of-payment crises,while the second type corresponds to second and more recent generations.

6. Such is the case of herding behavior from investors and contagion effects from othereconomies.

7. The increase in asset prices is usually referred to in the literature as a “bubble”.

8. For instance, the familiar topics of bank runs, bank panics, speculative attacks, andself-fulfilling crises, as seen above.


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9. For instance, an asset price crisis. When that is the case, we use the terminology “tripletcrisis”.

10. The methodology employed by Kaminsky and Reinhart (1999) is rather unpretentious andtakes into account only macroeconomic data of single countries. Certainly, there is room forimprovement by employing microeconomic data such as banks’ balance sheet informationand allowing for cross-country effects.

11. The triggering event could be an internal event such as a major policy change from thegovernment, political instability in general, incapacity of the government to sustain the fiscalbalance, or macroeconomic instability such as hyperinflation. Also, external events such asexternal changes in international liquidity, commodity price shocks that deteriorate thecountries terms of trade, and contagion from crises in other countries are often listed astriggers to financial crises.

12. During the 1990s, Brazil was affected by the following major crises: Mexican (1994-1995), adomestic banking crisis (1995-1997), Asian (1997), Russian (1998), a domestic currency crisis(1999), and Argentina (2001-2002).

13. See Desai (2003) and Eichengreen (2002) for a survey on financial crisis.

14. Although the subprime crisis had already affected credit in 2007, this paper assumes therecent events that provoked the so-called credit crunch starting by the bailout of Fannie Maeand Freddie Mac on September 7, 2008, as the beginning of the current crisis for practicalpurposes.

15. For a comprehensive view of causes and outcomes of the Asian crisis, see Berg (1999).

16. The Real Plan was launched in July, 1994 and successfully put an end to hyperinflation inBrazil. It used the exchange rate policy, a pegged currency, subject to a gradual devaluationof about 7 percent annually, to keep inflation under control.

17. The SELIC rate is the average overnight interest rate quoted in Sistema Especial deLiquidacao e de Custodia (SELIC), a clearing house for government securities.

References

Allen, F. and Gale, D. (2000), “Bubbles and crises”, The Economic Journal, Vol. 110 No. 460,pp. 236-56.

Berg, A.G. (1999), “The Asia crisis: causes, policy responses and outcomes”, Working PaperWP/99/138, International Monetary Fund, Washington, DC.

Blanchard, O.J. and Watson, M.W. (1982), “Bubbles, rational expectations and financial markets”,in Wachtel, P. (Ed.), Crises in the Economic and Financial Structure, D.C. Heath andCompany, Lexington, MA, pp. 295-316.

Brazil (2000), “Presidencia da Republica. Casa Civil. Subchefia para Assuntos Jurıdicos.Lei Complementar No 101, de 4 de maio de 2000. Estabelece normas de financas publicasvoltadas para a responsabilidade na gestao fiscal e da outras providencias”, Diario Oficialda Uniao, Brasılia, 5 May, p. 1.

De Long, J.B., Shleifer, A., Summers, L.H. and Waldmann, R.J. (1990), “Positive feedbackinvestment strategies and destabilizing rational speculation”, Journal of Finance, Vol. 45No. 2, pp. 379-95.

Desai, P. (2003), Financial Crises, Contagion and Containment: From Asia to Argentina,Princeton University Press, Princeton, NJ.

Diamond, D.W. and Dybvig, P.H. (1983), “Bank runs, deposit insurance, and liquidity”, Journal ofPolitical Economy, Vol. 91 No. 3, pp. 401-19.

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(The) Economist (2008), 25 October.

Eichengreen, B. (1999), Toward a New International Financial Architecture: A Practical Post-AsiaAgenda, Institute for International Economics, Washington, DC.

Eichengreen, B. (2002), Financial Crises and What to Do about Them, Oxford University Press,New York, NY.

Eichengreen, B. and Rose, W. (2004), “Staying afloat when the wind shifts: external factors andemerging-market banking crises”, in Calvo, G.A., Dornbusch, R. and Obstfeld, M. (Eds),Money, Capital Mobility, and Trade: Essays in Honor of Robert A. Mundell, MIT Press,Cambridge, MA, pp. 171-205.

Eichengreen, B., Mussa, M., Dell’Ariccia, G., Detragiache, E., Milesi-Ferretti, G.M. andTweedie, A. (1998), “Capital account liberalization: theoretical and practical aspects”,Occasional Paper No. 172, International Monetary Fund, Washington, DC.

Flood, R.P. and Garber, P.M. (1984), “Collapsing exchange rate regimes: some linear examples”,Journal of International Economics, Vol. 17 Nos 1/2, pp. 1-13.

Gavin, M. and Hausmann, R. (1996), “The roots of banking crises: the macroeconomic context”,in Hausmann, R. and Rojas-Suarez, L. (Eds), Banking Crises in Latin America,Inter-American Development Bank/The Johns Hopkins University Press, Washington, DC,pp. 27-63.

Goldstein, M. and Turner, P. (1996), “Banking crises in emerging economies: origins and policyoptions”, BIS Economic Papers No. 46, Bank for International Settlements, Basel.

Honohan, P. (2000), “Banking system failures in developing and transition countries: diagnosisand prediction”, Economic Notes, Vol. 29 No. 1, pp. 83-109.

International Monetary Fund (1998), “Financial crises: characteristics and indicators ofvulnerability”, IMF World Economic Outlook: Financial Crises: Causes and Indicators,International Monetary Fund, Washington, DC, pp. 74-97.

Kaminsky, G.L. (1998), “Currency and banking crises: the early warnings of distress”, Board ofGovernors of the Federal Reserve System International Finance Discussion Papers,No. 629, Federal Reserve System, Washington, DC.

Kaminsky, G.L. and Reinhart, C.M. (1999), “The twin crises: the cause of banking andbalance-of-payment problems”, The American Economic Review, Vol. 89 No. 3, pp. 473-500.

Krugman, P. (1979), “A model of balance-of-payments crises”, Journal of Money, Credit, andBanking, Vol. 3 No. 11, pp. 311-25.

Obstfeld, M. (1986), “Rational and self-fulfilling balance-of-payments crises”, The AmericanEconomic Review, Vol. 76 No. 1, pp. 72-81.

Rodrik, D. (1998), “Should the IMF pursue capital-account convertibility?”, in Kenen, P.B. (Ed.),Essays in International Finance, International Finance Section, Princeton University,Princeton, NJ, pp. 55-65.

Sachs, J., Tornell, A. and Velasco, A. (1996), “Financial crises in emerging markets: the lessonsfrom 1995”, Brookings Papers on Economic Activity, Vol. 27 No. 1, pp. 147-99.

About the authorsAndre Filipe Zago de Azevedo holds a PhD in Economics (University of Sussex, UK), an MPhil inEconomics (Universidade Federal do Rio Grande do Sul – UFRGS, Porto Alegre, Brazil), and aBA in Economics (UFRGS, Porto Alegre, Brazil). Currently, he is an Associate Professor of theGraduate Program in Economics at Universidade do Vale do Rio dos Sinos (UNISINOS), aResearcher of the Brazilian Research Council (CNPq), and the Economic Adviser of the Chambers


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of Commerce of the State of Rio Grande do Sul. Previously, he was a Consultant at the UnitedNations Conference on Trade and Development (UNCTAD). His professional and academicinterests are international economics, international trade, economic development, andinternational business.

Paulo Renato Soares Terra holds a PhD in Management (McGill University, Montreal,Canada), an MSc in Management (Universidade Federal do Rio Grande do Sul – UFRGS, PortoAlegre, Brazil), and a BA in Business Administration (UFRGS, Porto Alegre, Brazil). He is anAssociate Professor of the Graduate Program in Management of the School of Management(UFRGS, Porto Alegre, Brazil), Associate Researcher of Ecole des Hautes Etudes Commercialesde Montreal (HEC-Montreal, Montreal, Canada), and Visiting Professor (Fulbright Scholar) at theUniversity of Illinois at Urbana-Champaign (Illinois, USA). His professional and academicinterests are international business, international corporate finance, international corporategovernance, and international capital markets. Paulo Renato Soares Terra is the correspondingauthor and can be contacted at: [email protected]

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A time to return to KeynesSteven Pressman

Department of Economics & Finance, Monmouth University,West Long Branch, New Jersey, USA

Abstract

Purpose – This paper seeks compare the current financial and economic problems with the problemsfacing the world economy in the 1930s.

Design/methodology/approach – The paper argues that the Great Depression and the currentproblems have similar causes – excessive speculation, leading to a financial collapse that then resultsin an economic collapse. It then looks at the work of John Maynard Keynes to help solve the currentproblems.

Findings – The paper advocates a large public works program plus a number of policies to help UShomeowners and thereby stabilize housing prices.

Originality/value – The paper provides a way out of the current economic and financial problems,and a way to avoid another Great Depression.

Keywords Economic depression, Keynesian economics, Fiscal policy, Debts, Housing


As the Great Depression swept across the world during the 1930s, John MaynardKeynes began a book he thought would transform economics. In a letter to GeorgeBernard Shaw on January 1, 1935, Keynes wrote: “I believe myself to be writing a bookon economic theory which will largely revolutionize not I suppose at once but in thecourse of the next ten years the way the world thinks about economic problems”. Thebook came out in February 1936 with an extremely intimidating title, one alluding tothe revolution in physics begun by Einstein. It was called The General Theory ofEmployment, Interest and Money. The General Theory (Keynes, 1936), as it has come tobe called, provided an analysis of how economies worked as a whole, why things couldgo wrong and, most important of all, it told us what to do when facing economicproblems.

Keynes was right. The General Theory did radically change economics. Itestablished macroeconomics as a field within economics. In the years following theSecond World War, it transformed how politicians thought about the economy andhow they made policy decisions. Even President Nixon famously claimed “We are allKeynesians now”, as he employed Keynesian policies to help the US economy growand secure his re-election. Unfortunately, as a result of the work of Milton Friedmanand Robert Lucas, a backlash began in the late 1970s. This backlash picked up steamin the 1980s and early 1990s. By the turn of the twenty-first century, Keynes waslargely ignored. Laissez-faire or free market economics ruled the profession and thepolicy-making world. One result is that we now face the possibility of anotherdepression, brought on by another stock market crash and another credit crisis.

Keynes sought to explain why the world economy found itself mired in a GreatDepression and what could be done about it. The main message of The General Theorywas that spending drives economic activity. It did not matter who spent money;consumers, business firms, or the government could do it. When there is a great deal of



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Vol. 5 No. 1/2, 2009pp. 157-161


DOI 10.1108/17422040910938767

spending, jobs become plentiful and incomes rise sharply. In contrast, when firms andconsumers are reluctant to spend, we face recession and depression with very highrates of unemployment.

A second message of The General Theory is that capitalism requires that peopletake chances. But problems arise when capitalism is more about gambling thanproducing goods and services. As Keynes (1936, p. 159) noted, “Speculators may do noharm as bubbles on a steady stream of enterprise. But the position is serious whenenterprise becomes the bubble on a whirlpool of speculation. When the capitaldevelopment of a country becomes a by-product of the activities of a casino, the job islikely to be ill-done”. In the 1920s Wall Street did operate like a gambling casino. In thehope of becoming wealthy, people put little money down and borrowed a great deal ofmoney to purchase stock. Stock shares served as collateral on these margin loans.People came out ahead as long as the returns on stocks exceeded the interest cost ofborrowing. These gains could then be used to finance more speculation. But, like anyPonzi scheme, this required more and more money coming into the market and pushingup stock prices. The day of reckoning came in 1929 when the influx of new moneyslowed and some people decided to cash in their winnings.

Problems became serious in October 1929 when the stock market crashed. AsKeynesian economist John Kenneth Galbraith documents in The Great Crash – 1929(Galbraith, 1954), once the market started its decline, there came the inevitable margincalls. Those who borrowed money to buy stock had to come up with more moneybecause the value of their collateral had declined. This led to more selling, and as themarket continued to fall, more margin calls went out and more selling took place,leading to even further rounds of margin calls and selling. Banks, which speculatedheavily in stocks, were in a great deal of trouble. They were facing withdrawals bydepositors to meet margin calls, and they too had to meet margin calls on their stockpurchases. Making things worse, with the economy slowing down, people and firmsbegan to default on their bank loans. Under normal circumstances, when loans arerepaid, the money gets lent out again as soon as possible – this is how banks makemoney. But when defaults mount, it is harder for banks to make new loans. Moreover,as people became worried about the safety of their money in the bank, they startedmaking withdrawals. This too was money that banks could not lend out. The resultwas a series of bank panics, bankruptcies, and a decade-long Great Depression. This iswhere Keynes comes in.

The conventional wisdom at the time was the need for “sound money” and “soundfinance”. Sound money meant that we could not just print up money and give it tobanks to lend. Sound finance meant that the government had to keep its budgetbalanced. These shibboleths exacerbated the problem, as Keynes explained. Soundmoney meant that banks could no longer lend to businesses or to households wantingto spend but lacking ready cash. Sound finance meant that governments had to raisetaxes and cut spending so that lost tax revenues due to joblessness would not result inbudget deficits. All this made a bad situation worse.

Keynes pointed out that in difficult economic times, someone has to spend.However, households lacked jobs; those with jobs feared for them and were not likelyto go on a spending spree. Similarly, business firms were reluctant to expand when thedemand for goods was falling. Even if they wanted to expand, they would need toborrow money. Given the problems facing banks, and their unwillingness and inability

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to lend, this was not likely. That leaves the government as the only possible spender. Inone of the more famous passages in The General Theory, Keynes provided specificexamples of what should be done. He called for more hospitals, more schools and moreroads. But he noted that many people objected to such “wasteful” forms of spending.Another approach was therefore necessary. Keynes then provided such an approach.He called for the Treasury to print banknotes, bury them at suitable depths inabandoned coalmines, and then fill the mines to the surface with rubbish. With moneyclearly to be made, private enterprise would dig up the notes, hire workers to help inthe endeavor, and unemployment would disappear.

We again face the problems of the 1930s, and we again need to heed Keynes’sadvice. The balance sheets of many financial institutions are currently a shambles dueto excessive speculation in mortgage-backed securities. As individuals default on theirmortgages, banks cannot make new loans. And as these mortgage packages decline invalue, banks lose the capital that is necessary for them to function; they teeter on thebrink of bankruptcy. With credit hard to obtain, borrowing and spending fall, and theeconomy heads into a severe recession. In the face of these problems, stock pricestumble. Another Great Depression becomes a distinct possibility. Many financialinstitutions have already gone under or have been bought out by other financialinstitutions with government assistance. After much delay and numerous mistakes,governments throughout the world have come to realize the need to buy up these badloans and also to provide banks with the capital that is a perquisite to making newloans. The shibboleth of sound money appears to have been defeated.

But this is only half the job, as Keynes recognized. Just because banks can lend doesnot mean that they will lend. As we have seen, even after the US Congress passed a$700 billion bailout plan and even after developed countries decided to provide thecapital banks that need, not much has changed – credit remains hard to get and stockprices have remained depressed. The problem is that lending also requires that there besomeone willing to borrow and spend. As Keynes taught, if consumers and businessfirms are not willing to do this, the government must do it.

Printing money and burying it in abandoned coalmines is a rather silly way tocreate jobs. It would be much better to do those things that need to be done and thatwould make people’s lives better. There is no shortage of what needs to be done in theUSA today. Besides the crumbling roads, an insufficient supply of modern hospitalsand the sad state of education, there is also a need to develop alternative energysources to stop global warming. And as state and local budgets face massive deficits,with looming tax increases and spending cutbacks, the Federal government canprovide money to lower levels of government and direct that it be spent on providinglocal services and maintaining public employment. Creating three million jobs at a costof around $50,000-$60,000 apiece (pay and benefits), would cost the US governmentaround $150 to $175 billion. This is less than one-third of the Wall Street bailout plan.But such action is necessary.

But we also need to deal with the causes of the problem – sinking home prices andmassive consumer debt. This requires additional policy actions. First, we need tostabilize home prices. One way to do this is through tax relief to homeowners. A simpleway to do this is to convert current tax deductions for mortgage interest and propertytaxes into refundable tax credits. At present, most middle-income homeowners getmeager tax breaks on these payments because they are in relatively low tax brackets.


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Low-income homeowners generally get back nothing because they generally do notitemize deductions and owe little in taxes. A refundable tax credit, set near the topmarginal tax rate (essentially the rate of government housing subsidy for the wealthy),would assist all households with their housing expenses. To minimize the cost and tothe keep large benefits from going to wealthy Americans, we just need to cap themaximum credit available. Making this change effective January 2008 would givemany middle and lower income homeowners a large tax break immediately, thus alsostimulating the economy.

Second, to aid homeowners we also need to do something about interest rates. Hadthis been 50 years ago people would have gone to their bank and negotiated a lowermortgage rate. Everyone would benefit – banks would get repaid rather than owningabandoned property, and families would be able to pay their mortgages. Todayfinancial institutions sell individual mortgages and buy back a package containingparts of individual mortgages; unfortunately, banks cannot renegotiate the terms ofwhat they do not own. This is where the government can step in. Even Adam Smith,the father of economics and a strong advocate of the free market, recognized thatinterest rate limits might be necessary. They are needed now!

Despite the media hype about subprime mortgages, the real villain is the variablerate mortgage. It is not hard to understand why. People with fixed rate mortgagesaccepted an interest rate that enabled them to make their monthly mortgage payments.Those with variable rate mortgages were enticed by low initial payments andrefinancing promises. When mortgages reset, households faced rates they could notafford; and with no equity in their homes, they could not refinance. Capping ratesmakes it easier for households to make their monthly mortgage payments and keeptheir homes. Financial institutions holding mortgage-backed securities will benefitfrom fewer delinquencies and foreclosures. When 30-year fixed rate mortgages aregoing for around 6 percent, there is a good case for capping rates at 7 or 8 percent forseveral years. This is much quicker and much simpler than other proposed solutionsthat require someone renegotiating mortgages whose parts are held all over the world.

Third, credit card debt in the USA must be reduced. This is likely to be the next bigcredit crisis. Credit card debt has reached the highest level in US history, and exceedsthe ability of many households to repay that debt. As lenders fear greater defaults andare less able to lend, they are making things worse by raising interest rates on creditcards. This makes it harder for consumers to spend money on new goods and servicesand to pay their mortgages. Part of the problem is that households can no longereliminate their debts easily by declaring bankruptcy. Congress passed the BankruptcyAbuse Prevention and Reform Act of 2005 after years of large financial contributionsfrom the credit card companies. This law made it harder and more expensive forhouseholds to wipe out their debts under Chapter 7 bankruptcy. Many householdsmust now use Chapter 13, under which they must pay back a good chunk of their debt.

Until the backlog of consumer debt is dealt with, there will be little hope for aresurgence of consumer spending and little hope of a sustained recovery. There areonly two ways to deal with this debt – we can force consumers to tighten their beltsand pay off this debt slowly, or we can eradicate the debt quickly and give consumersthe ability to spend again. Returning to pre-2005 bankruptcy laws, until a new andbetter law can be enacted, is thus a priority.

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Finally, we need to heed Keynes’s advice about capitalism and make sure that theseproblems do not occur again. When we forget the lessons of history, and just think ofthe riches that can be made now if only the government would let the free market work,the result is that capitalism does come to resemble a gambling casino. This means thatwe need greater regulation of financial institutions. It also means severe penalties forthose who promulgated the speculative frenzy – if for no other reason than to serve asa warning to those who might be inclined to take the money and run. Those pushingsubprime mortgages on households because underwriting fees were greater must beprosecuted for fraud. CEOs and senior executives must also suffer great publichumiliation. A strong message must go out that the gains from such activities will notbe as great as the possible losses and that such behavior is not acceptable.

References

Galbraith, J.K. (1954), The Great Crash – 1929, Houghton Mifflin, Boston, MA.

Keynes, J.M. (1936), The General Theory of Employment, Interest and Money, Macmillan,London.

About the authorSteven Pressman is Professor of Economics & Finance at Monmouth University, Co-Editor ofReview of Political Economy, and Chief Financial Officer of the Eastern Economic Association. He isthe author of more than 120 articles, and author or editor of more than a dozen books, including FiftyMajor Economists, 2nd ed. (Routledge, 2006). He can be contacted at: [email protected]


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International business andthe crisisJan Toporowski

School of Oriental and African Studies, University of London, London, UK andthe Research Centre for the History and Methodology of Economics,

University of Amsterdam, Amsterdam, The Netherlands

Abstract

Purpose – The purpose of this paper is to highlight the effects of the financial crisis on internationalbusiness.

Design/methodology/approach – The paper argues that international business is differentiatedby line of business and country of operation.

Findings – The crisis will therefore affect international business according to how exposed suchbusiness is to international finance. Alongside the financial implications of the crisis, fallinginvestment will reduce profits and liquidity in all business sectors.

Originality/value – The most original feature of the paper is an argument that recent developmentsin international business have been led by financial market inflation, rather than by the autonomousmanagerial strategies of international businesses.

Keywords Recession, Financial markets, Multinational companies


It is extremely difficult to generalise about how the current financial crisis will affectinternational business, or multinational companies. Multinational companies tend tospecialise in particular industries. All of these industries are subject to cyclicalfluctuations that tend to be peculiar to each industry, although we are now about to seethese cycles coincide as particular economies and regions succumb to generalisedeconomic depression. Furthermore, multinational companies do not all operate equallyacross the whole world. Their operations are usually concentrated in particular regionswith links to particular financial centres. While many of these financial centres aremore or less affected by the financial crisis, not all regions in the world are affected bythat crisis. For example, India and China remain to date (the end of October 2008)relatively unaffected by the crisis, although this does not mean that they will not beaffected in the future. Because of this differential geographical impact of the crisis, itwill affect multinational companies differently according to where their operations andtheir financing may be concentrated.

Perhaps the only generalisation that can be made about international businesstoday is that it enters the present period of crisis and instability in remarkably goodfinancial condition. As a result of the stock market inflation of recent years, largecorporations have all raised capital in excess of their commercial or industrialrequirements. Such excess capital is usually held as short-term financial assets (banksdeposits, commercial paper) or else as holdings of shares in other companies. Certainlyby comparison with banks in general, and many banks operating multinationally,international business has strong balance sheets and mostly good margins of solvency.



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The difficulty for multinational companies is that these margins of solvency, in theform of liquid assets, will now drain away as households raise their saving rates. Fiscaldeficits, which would normally increase the net income of the corporate sector, will beincreasingly directed towards refinancing banking systems. Reserves, built up fromcapital gains on assets such as palatial headquarters buildings, will be reduced as assetprices fall. Falling fixed capital investment in the financially advanced countries, andin China, whose investment has powered the recent industrial and commodity boomsof many countries, will further cut the net income of businesses. Internationalbusinesses, although in a strong position in many markets, will not be able to avoid theconsequences of the contraction of those markets. Postponing new investment projectswill only further squeeze new income for other businesses.

In this situation even businesses that manage to avoid substantial falls in sales,because of their size and the scale of their international operations, will be inclined tohold on to liquid assets rather than investing. But firms can only do this at the expenseof other firms’ sales revenue. So, while international business is in a better position toride out the forthcoming recession than most smaller businesses, it will also contributemore than most towards creating that recession by withholding more expenditure thanmost. Lakshmi Mittal may save money by cutting the capital expenditure of hisinternational steel company Arcelor Mittal. But the suppliers of his capital equipmentwill lose that revenue, and those capital equipment manufacturers also use prodigiousamounts of steel in their production. In any case, the rationale for investment is weakwhen a fall in global steel demand of 20 per cent and more is expected.

A second consequence of the international financial crisis that will undoubtedlyaffect international business will be capital controls. It is very clear that manycountries will now adopt or strengthen controls on foreign capital inflows and outflowsin order to stabilise their financial systems. In the past foreign capital controls wouldhave brought disapproval from the multilateral agencies charged with policing theinternational financial system – the International Monetary Fund, the World Bank, theOrganisation for Economic Co-operation and Development, and behind them the USA– disapproval reinforced by the threat of exclusion from IMF-led financing. But thiswas because past crises were international banking crises that these agencies hoped toresolve by refinancing bank debt through the capital markets.

Not only has the international climate of opinion towards capital controls changed.As before, the financing capability of the IMF is limited by comparison with thefinancing requirements for alleviating the crisis. The IMF is therefore acting as a leadagency to facilitate other sources of finance. However, since the other sources havebeen frozen up by the crisis, an important element in the additional financing havebeen central bank swap facilities that have been extended by the US Federal Reserve tocentral banks in Mexico, Brazil, and South Korea. In Europe, the European CentralBank has extended such facilities to central banks in Hungary, the Czech Republic andother new member states. In the case of Iceland, such facilities are being provided byScandinavian central banks. Such assistance is being targeted on particular favouredcountries in difficulty. But because much of the banking systems in the beneficiarycountries, in many cases most of the banking system, is multinational a more benignview is likely to be taken of capital controls. Capital controls would be necessary toprevent multinational banks from drawing down central bank assistance in a country

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benefiting from such swap facilities in order to assist bank subsidiaries in another lessfavoured country.

Capital controls will tend to freeze the present hierarchy of multinational companies,if only because competitors or potential competitors will find it more difficult to financemergers and acquisitions in a declining capital market. It is a staple of business schoolresearch that most mergers and acquisitions do not improve the financial results of thecompanies being combined in this way. The rationale for mergers and acquisitions wasin fact provided by capital market inflation, which made buying companies for resaleat a higher price in an inflating market a profitable business proposition. Thispossibility no longer exists because of the large falls in the main stock markets of theworld. Worse, most multinationals have their stocks quoted on more than one majorstock exchange. This means that selling pressure frustrated by falling prices in onemarket is transmitted to other markets. Stockholders unable to sell a sufficient amountof stock in one market, because of the effect that this may have on prices, will distributetheir selling across more than one market. Frustrated selling pressure will alsofrustrate the selling of new stock. The resulting inability to raise financesimultaneously in a number of countries will act as an informal capital control. Thedays of the multinational business that made money from restructuring its balancesheets in different countries is at an end. The prospects for making money in the moretraditional way of production and technological innovation are not good.

Inflating asset markets dominated by investment bankers earning pro rata fees forbalance sheet restructuring has provided a very congenial ambience for internationalbusiness theories that can provide some managerial rationale for such restructuring.Declining asset markets will be correspondingly uncongenial for such theories. Fallingprofits will reduce the supply of successful companies providing case studies of the“excellence” attributed to alleged “competitiveness”, “capability”, “internal advantage”,“synergy”, “competences”, or some other mystical source. Furthermore, financialausterity will make it much more difficult to secure financial backing for managementstrategies driven by speculative theoretical projections. As the present crisis reveals,financial asset inflation was the source of much of the financial success of internationalbusiness and the most common means by which international business could emergeand thrive. For those researching the problems of international business, the onlyeffective approach to understanding the subject, the crisis provides an unrivalledopportunity to uncover the true constraints that determine the character and dynamicsof cross-border capitalism.

About the authorJan Toporowski has worked in fund management, central banking and international banking. Heteaches at the School of Oriental and African Studies, University of London, and is a ResearchAssociate of the Research Centre for the History and methodology of Economics at theUniversity of Amsterdam. His most recent book, Theories of Financial Disturbance, waspublished by Edward Elgar in 2005. He can be contacted at: [email protected]

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Reflections on a Global Financial Crisis (Critical Perspectives on International Business)

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