THE GLOBAL FINANCIAL CRISIS VIEWED THROUGH THE

THEORY OF SOCIAL COSTS

L. Randall Wray

Levy Economics Institute and

University of Missouri - Kansas City

www.levy.org; www.economonitor.com/lrwray;

wrayr@umkc.edu

Orthodox: Efficient Markets• Theory:

• Modigliani-Miller: Finance doesn’t matter• Efficient Markets: Fundamentals drive Asset Prices• Transversality Condition: No Defaults

• Policy Implications: • Basle, Self Supervision, Ratings Agencies, Internal Models• Finance is a “scarce resource”; Government’s role is to get out of

the way so that markets can “efficiently allocate” it

Reality: An Overview• As Coase argued most financial transactions take place outside markets.

• Finance is fundamentally a “relationship” business, not a market• Finance is not a scarce resource; it is “accepting” IOUs of the credit-worthy

• Default riskFDIC, LOLR to stop runs and ensure par clearing• Banks operate payments system in public interest; Govt backstops

• Glass Steagall separated Investment banking from Commercial banking and kept IBs out of payments system • but shadow banks “poached” and CBs were deregulated to do their own

poaching

• Rise of BHC, Affiliates, Complex and Unknown linkages, Off-balance sheet liabilities and SIVs and SPVs, Counterparty risk exposures through derivatives

Causes of the Collapse

• The Minsky Moment

• Minsky’s Stages

• Money Manager Capitalism

• Financialization, Layering, Liquidity

• Fraud and the Real Estate Bubble

• Shredding of New Deal Reforms

• Bubbles, Goldilocks and Budgets

Minsky Moment

• Financial Instability Hypothesis

• Investment Theory of the Cycle and Financial Theory

of Investment

• Hedge Speculative Ponzi

• Big Bank and Big Government Rescue

• Stability is Destabilizing

Boom and Bust• 1980s Thrift & Bank Crises

• Thrifts and Commercial real estate• Banks and LDC debt

• 1980s Leverage Buy-outs• Michael Milken and Junk Bonds

• 1990s New Economy and Nasdaq• “Irrational Exuberance”

• 2000s Residential Real Estate• Subprimes; foreclosures

• 2000s Commodity Markets• Quadrupled oil prices; food riots; starvation

Each follows the pattern and each crisis is worse than the previous

A Minsky Half-Century?• Stages Approach: 57 Varieties

• Commercial capitalism• Finance capitalism• Paternalistic (Managerial-Welfare State) capitalism• Money Manager capitalism

• Stability bred instability• Accumulation of financial assets/liabilities• Globalization• Securitization• Self-supervision

Decreasing Weight of the Banking Sector

Shares of Financial Institutions (% of Total Assets)

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life insurance companies

Managed Money

Funding Corporations

Security Brokers and Dealers

Real Estate Investment Trusts

Finance Companies

Issuers of Asset-Backed Securities

Agency and GSE-backed MortgagePoolsGovernment-Sponsored Enterprises

State and Local Government RetirementFundsCredit Unions

Saving Institutions

Bank Holding Companies

Commercial BankingSource: Federal Reserve Flow of Funds Accounts

Managed Money

Commercial Banking

Financialization, Layering, Liquidity• Rising share of profits and value added going to financial sector.

• Layering debt on debt on debt.• Positions in assets financed through very short term

(overnight) borrowing.

• Asset mkts and institutions tightly linked in complex ways

• Liquidity and hedges were a mirage

• Casino-like speculation dominates.

Financialization of the U.S. Economy

   195

5   

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6   20

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Financial Industry Share of Corporate Profits and Value Added (1955-2010)

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Households and nonprofit

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GSEGSEGSEGSEGSEGSEGSEGSEGSEGSEGSEGSEGSEGSEGSEGSEGSEGSEGSEGSEGSEGSEGSE

GSEGSE

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Total Financial Liabilities Relative to GDP

Sources: Historical Statistics of the United States: Millennium Edition (Tables Cj870-889, Ca9-19, Ce42-68, Cj787-796, Cj748-750, Cj389-397, Cj437-447, and Cj362-374), Historical Statistics of the United States: Colonial Times to 1970 (Series X 689-697), NIPA, Flow of Funds (from 1945).

New Home Finance Model• Jimmy Stewart’s Thrift: loan officer, bank teller, home

appraiser; public recorder.

• Loans held to maturity

• New more “efficient” Wall Street model:

• Involves broker, appraiser, lender, servicer, MERS, securitizer, credit rater, rocket scientists and proprietary models, MBS trustee, CDOs squared and cubed, CDSs and monolines, investors, traders, accountants, lawyers, lender processing services; robo-signers and document “recovery” services (forgery).

• Model: originate to distribute, pump and dump, foreclose and resell.

• Capitalizing unrealizable home values.

Real Estate Bubble and Fraud

• Like Shrek’s onion: Every link in the Home Finance Food Chain was fraudulent: • Appraisers, brokers, lenders, MERS recording,

investment bank securitizers, trusts, CDOs squared and cubed, CDS bets on failure, accounting firms, ratings agencies, and servicers.

• Most fraud was on part of lenders, and now servicers.• Fed recognized growing fraud as early as 2000; FBI

warned in 2004 “epidemic of fraud”.

WHY????????????• Why the complexity and fraud at every layer?• Model was flawed from beginning: could not have been

profitable; interest payments could not cover costs,• Needed mortgages @ 120% of value to book fees,

• Complexity essential to hide accounting fraud.• The beauty of a Casino: the house always wins.

• $10T of homes tens of trillions of dollars of bets.

• Foreclosure was inevitable, desired, outcome: bet on failure then reboot thru foreclosure and to hide the fraud.

• Galbraith: The Great Crash. Like 1929 investment trusts.

Shredding of New Deal Reform

• Deregulation, de-supervision, self-supervision

• Rising inequality

• Falling wage share

• Rising consumer debt

• Fiscal constraint

Wages and Salaries, % of GDP

Financial Bubbles, Goldilocks and Budgets

• Greenspan “Put”; Bernanke “Great Moderation”.

• No bubbles in sight. Fundamentals are strong.

• Reality: biggest debt, equity, commodity, and real estate bubbles in history.

• Propped up by Big Government and Big Bank—No cleansing through debt deflation dynamics.

GFC 2007: It all started with Goldilocks

• 1996: US Federal Government begins surpluses; continued for 2.5 years.

• Clinton projects surpluses for next 15 years.• All Government debt will be retired.• Fuels securitization

• Private debt explodes. Why? The Three Balances.• The Meaning of Zero:0=Private Balance + Government Balance + Foreign Balance

Bail-out!

• Fiscal Stimulus $800B.

• Hank Paulson $700B. Don’t ask, don’t tell.

• Toxic asset purchases, capital injections

• Fed: Unprecedented effort

• Peak $1.7 Trillion

• $29 TRILLION cumulatively

Unusual and Exigent Circumstances• Liquidity or Solvency Crisis?

• Bagehot: lend w/o limit, against good collateral, at penalty rate• Banks relied on extremely short-term finance, questionable

assets refusal to roll-over: solvency problemsliquidity crisis• “Liquidity provisions” through alphabet soup facilities• Benny and Timmy do Monty Hall: Let’s Make a Deal!

• Treas-Fed Negotiations, bridge loans, “orderly solutions” • Subvert mkt processes, force losses on owners, rescue creditors

• Fed’s Special Purpose Vehicles subvert 13(3) constraints• Lending to SPVs to lend and buy toxic waste• And to Real Housewives of Wall Street through nonrecourse loans

• QE 1, 2…..3?

Accounting for the Bail-out• Act of Congress and FOIA by Bloomberg• How to measure? Peak versus Cumulative• Peak: Dec 2008, $1.7 T• Cumulative through Nov 2011: $29,800,000,000,000

• Individual institutions funded up to two years• 20% “conventional” to depository institutions• 80% “nonconventional” (nondepository, markets, assets)• 40% “questionable” by 13(3) restrictions: $11T• Highly concentrated among biggest domestic and foreign

institutions• These figures exclude QE

Select Fed Assets, 1/3/2007-9/2011

Mortgage Backed Securities

Select Fed Assets, 1/3/2007-3/1/2012

0

500

1000

1500

2000

2500

3000

3500

All other assets

U.S. Treasuries (includes QE)

Unconventional Asset Purchases (MBS & Federal Agency Securities)

Unconventional LOLR (TAF,TSLF/TOP, PDCF, AMLF, AIG RCF, TALF, CPFF, ML I,II, & III, AIA/ALICO, CBLS)

Conventional LOLR (Discount Window and Repurchase Agreements)

Total Institutional Participation, excluding CBLS

UBS AG (Switzerland)2.2%

RBS3.2%

Morgan Stanley11.6%

Merrill Lynch12.4%

JP Morgan Chase2.3%

Goldman Sachs5.1%

Deutsche Bank AG (Germany)3.6%

Credit Suisse (Switzerland)4%

Citigroup13.6%

BNP Paribas (France)5.1%

Bear Stearns5%

Barclays5.3%

Bank of America5.2%

AIG5.4%

All others16.1%

Almost 84% involvedjust 14 institutions!

Why Mainstream Gets it Wrong1. Financial sector is not operated as a “market”—at least one as conceived by neoclassical economics.

2. Not equilibrium-seeking, rather, it evolves toward fragility. 3. Competition among financial institutions does not promote the public interest, rather, it creates costs and shifts them to society.

4. Management of financial institutions have increasingly adopted practices that enrich themselves—control fraud—not only at the expense of customers but also at the expense of the reputation of the firms.

In other words, the shifting of costs is in part onto the firms, themselves—many of which did not survive the crisis (and many more will fail).

The GFC and Social Costs• Safety req’d underwriting; but innovations and deregulation

eliminated it • Originate to Distribute, Pricing based on Internal Models; Pump and Dump

Control Frauds (Rewards to CEOs, not Owners or Customers)• Finance moves ever farther from Minsky’s “Capital Development”

of the Economy • Predatory lending to strip equity (Vampire Squids)

• Bail-out rewards “innovations”, socializes costs and privatizes benefits • Promotes Bubbleonia and Ownership Society and wasted resources (labor,

abandoned houses and uncompleted projects) • Foreclosed property and destroyed ownership records

• Burdened local government and imposed higher local taxes, pension fund losses, falling home prices stall recovery

• Will take a decade to sort out property records

End Game for Money Manager Capitalism

• Renewed problem at major banks could set off GFC 2.0

• Radical euthanasia: major banks will fail.

• Managed funds will fail: pensions, sovereign wealth funds, mutual funds, insurers, hedge funds.• That is a good thing!

• Minsky’s “simplification”of the financial system.

• Will emerge with little private debt, massive government debt robust financial system; Constrained with new laws, supervision.

• Return to underwriting, hold to maturity.

• Financialization replaced with New Deal 2.0: Higher Wages, Full employment, Domestic Consumption.

THANK YOU

L. Randall Wray, Levy Economics Institute and University of Missouri—Kansas City

www.levy.org; www.cfeps.org; wrayr@umkc.edu

BLOGS: NEP: http://neweconomicperspectives.blogspot.com/Great Leap Forward: http://www.economonitor.com/lrwray/