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«Tamara Lothian* Columbia University – Center for Law and Economic Studies Roberto Mangabeira Unger* Harvard University March 1, 2011 * © Tamara ...»

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Escalating household indebtedness, crucial to the continuing exuberance of the mass-consumption market, and therefore to the prosperity of the 16 firms that directly or indirectly produced mass-consumption goods, was in turn made possible in part by the overvaluation of the housing stock as collateral. Such an overvaluation, in the context of widespread abuse and regulatory laxity in the mortgage market, turned out to be one of the immediate triggering mechanisms of the crisis, in its American epicenter as well as in many of the countries that suffered most from the crisis, among them Spain, Ireland, and Britain.

Thus did a pseudo-democratization of credit replace a real redistribution of wealth and income. A fragile credit democracy came to stand in the place of a property-owning democracy.

The surplus countries, China first among them, had much of their mass-consumption markets abroad, in the countries to which they sold their goods and services. Such countries replaced redistribution not with credit but with exports -- exports to countries that had put credit in the place of redistribution.

Inequality matters, however, also in another, deeper and less direct way that has more to do with the supply side of the economy than with its demand side, and with firms rather than with households. In all major economies in the world, the most important, wealth-creating innovations have come increasingly to be concentrated in advanced sectors of the economy, strongly connected to comparable productive vanguards around the world -- with which they trade people, practices, and ideas -but only weakly linked to other parts of their own national economies.

The result is that the greatest engine for dramatic rises in productivity finds its potential diminished by the narrowness of its scope of operation and influence. It is a formidable constraint on any attempt to make the slump give way to a new cycle of enduring and broad-based economic growth.

Here are twin imperatives that the established debate about the 17 crisis has left almost entirely untouched: the need to put finance more effectively at the service of the real economy in general, and of production and innovation in particular, as well as the need to loosen the destructive restraints that inequality imposes on growth.

The ideas of regulation and reform that have thus far been presented in the United States and other advanced economies do not even come close to addressing these twin problems, much less to proposing solutions to them. These ideas can be classed under the heading of four main agendas of reform and regulation. Each of them has been prominently championed, by a distinct group of advocates and constituents, in the United States and in other rich industrial democracies.

The first agenda is a classic New-Deal style agenda (as exemplified, for example, by the proposals of the Volcker committee). It wants to reinstate precautions, such as the division between insured deposit taking and proprietary trading, that were prominent in the American and European regulatory response to the Depression of the 1930s but that have since been relaxed. Its characteristic concern is to insulate the part of the banking system on which the general public relies against the excesses of speculative finance.

The second agenda is a New Technocratic agenda. Its sponsors are the high governmental officials in the Finance or Treasury ministries of the United States and the other advanced economies, and their academic allies. Its defining concerns are the strengthening of supervisory and resolution authority -- that is to say, authority to take over, close down, or turn around failing financial institutions, especially when their instability threatens the stability of the financial system as whole. The perspective is very clearly, as one of the favorite metaphors to emerge in the crisis reveals, “to put out a fire.” If it is an “eight-alarm fire,” the available instruments are regarded as insufficient. Once the fire is put 18 out, everything can presumably go back to the good old days before the conflagration.

The third agenda can be called the Basel agenda. Its source is the intellectual and bureaucratic elite of international high finance, as represented in its iconic institution, the Bank of International Settlements in Basel. Its concern is to contain or counterbalance the risks of financial instability. It characteristically proposes to do so by imposing more severe standards on the relation between the capital structure of banks and the risks and liabilities to which they are exposed.

It wants, for example, to make the banks conform to more stringent capital adequacy requirements.

The fourth agenda, the only one with overtly popular concerns, is a Consumer Protection agenda. It seeks better to protect the public against the abuses of the finance industry, through a combination of regulatory paternalism and mandated transparency. Its favorite instrument is a Consumer Protection Agency in the area of finance.

Taken together, these agendas of reform fail to deal, even in fragmentary and oblique fashion, with the twin structural problems that are central to the genealogy of the crisis and the slump. They also do nothing to remedy the consequences of the relative inefficacy of monetary and fiscal stimulus. It may well be said that it was never their purpose do so. Their intent, so the argument would go, was to discipline finance and to prevent it from continuing to do, or from one doing once again, the harm that it has just done to the livelihood and welfare of millions of people. It is therefore fair to ask whether any or all of these agendas are in fact able successfully to address the trouble with finance.

The answer to this question is no.

The two troubles with finance

19 Grant that the policies of stimulus espoused by the vulgar Keynesians cannot and will not be deployed at the scale that, according to their proponents, would be necessary to ensure a vigorous recovery. Concede that even if they were, they would not, all by themselves, suffice to secure the benefits that they are hoped to produce. Admit that the agendas of reform and regulation that have thus far commanded attention and authority have little potential to reach the deeper causes of the crisis and the slump.

Even so, you may protest, what has been accomplished is to reaffirm, in practice as well as in discourse, the need to control finance and never to forget that it is “the squeaky wheel of capitalism,” the flaw through which an otherwise vibrant economy may become vulnerable to calamitous disruption. At least here, it might be supposed, there has been success: advance in insight, making possible progress in law and policy.

An indisputable merit of the economics of Keynes as well as of the economics of the vulgar Keynesians is that the latter as well as the former view a market economy as having problems and possibilities very different from those of a barter economy, and refuse to see money as merely a transparent and innocuous instrumentality of real economic transactions. In the academic analysis of the crisis and the slump, as well as in the policy debate about how best to respond to them, finance has loomed large. Together with proposals to extend or to retrench fiscal and monetary expansionary policies and ideas about how best to redress the mass imbalances between surplus and deficit countries in world trade and capital flows, the call to regulate or re-regulate finance holds the center of attention in every country touched by the slump and by the crisis from which it resulted.

To no avail. The ruling ideas continue to prevent us from grasping the real trouble with finance. The discussion of finance has followed the psychological bias of pre and post-marginalist Anglo-American 20 economics, aggravated by the abuse of mathematics (as a substitute for causal reasoning rather than as an expression of it) in contemporary economic analysis.

A characteristic idea emerging from the present discussion of finance is that there is tendency, entrenched in our habits of mind, to underestimate the significance of uncommon and extreme events. Such events, we are taught, fall outside the established data sets. They occur more frequently than even the most sophisticated are inclined to expect.

When they occur, they break the bank, literally and metaphorically, and give force to the expression: all bets are off.

The rough and hazy distinction between ordinary and extraordinary calamities, bearing on finance, gains a specious semblance of theoretical clarity and grounding when it is interpreted in the context of a contrast between quantifiable risk and unquantifiable uncertainty. The distinction confuses flaws in knowledge with features of the world; it trivializes our ignorance as if it were simply a failure to register a natural difference between two classes of economic phenomena. Our quantification of risk can be only as precise and as reliable as our insight into the causal processes that change pieces of reality. If there are changes that seem unexpected and unaccountable on the basis of our established causal ideas about economic activity, that must be because those ideas are defective. Whether or not we are able to correct their defects, our first interest is to acknowledge them.

Both the occurrence and the effects of traumas and catastrophes in the realm of finance are shaped by the institutional arrangements and the enacted beliefs that organize financial activity and determine its relation to the real economy. They are not natural phenomena. For all these reasons, it is safe to say that the trouble with finance is not that we have thus far failed to recognize and to guard against a category of extraordinary financial calamities forming an intrinsic and perennial 21 feature of economic reality.

The real trouble with finance is two-fold. To appreciate the nature of these two sources of trouble and the relation between them is to acquire part of the intellectual equipment that we need the better to address, without superstition, the problems of the slump.

The first trouble with finance is that it operates in an institutional setting not of its own making from which there arise destabilizing forces that it cannot control. In fact, financiers can only partly understand these forces, much less manage them, from the vantage point of their activity.

Each of these sources of instability represents at least a partial cause of one of those varieties of danger that, according to the now fashionable discourse, generate unquantifiable uncertainty rather than unquantifiable risk.

That finance operates in an institutional context not of its own making is simply a special case of a more general truth: that the market economy cannot produce its own institutional framework. The institutions of the market are not created in the market. They are fashioned in politics as well as in thought, and embodied in law. The idea that the market in general, and the financial market in particular, generate their own institutional form becomes plausible only in the light of another idea, the practical influence of which in the affairs of modern societies can hardly be overestimated. This is the idea that a market economy has a single necessary and natural form, expressed above all in a particular system of rules and rights of contract and property.

It is an idea underlying much of the contemporary discussion of finance and of the regulation. One of its implications is that the proper task of regulation -- of finance or of any other branch of market activity

-- is to remedy particular market defects, of imperfect competition or asymmetrical information. What this idea disregards is what may be the 22 most important in the work of regulation and reform: the reshaping of the arrangements that define the market economy in every area including finance. If, as is in fact the case, the market economy has radically different institutional forms, expressed in law, with distinct consequences for the path of economic growth as well as for the distribution of wealth, power, and income, a discourse about localized market flaws and remedies for such flaws is incomplete. The issue is always also: which market economy do we want, and what way of solving today’s problems will help us move toward it.

Consider an open, partial list of attributes of the institutional setting in which finance operates and from which there may arise destabilizing forces that overwhelm the calculations and expectations of the money men.

A first attribute of this setting is at once negative and fundamental.

It is that the institutional context within which finance operates at any given time is a relatively ramshackle construction; it is not the unavoidable expression in legal detail of the necessary organization of a market economy. It is the surprising and contingent outcome of practical and visionary contests, stretching back in time. It is susceptible at any moment to piecemeal revision, no less decisive in its influence for being fragmentary.

Consider, as an example, the institutional context of American finance at the time of the outbreak of the recent crisis. A simple way to describe it is to say that it was the product of a partial hollowing out of the regulatory framework of finance established at the time of the New Deal. The uneven hollowing out took place under the prodding of that loose combination of practical and intellectual influences that is responsible for much of institutional change in history: the economic power gained by high finance, translated into political influence, and the intellectual influence of theoretical and practical ideas that came to 23 prominence in that period. Among the theoretical ideas were doctrines such as rational expectations theory and real business-cycle theory that discounted the efficacy of governmental action in a range of economic affairs. Among the practical ideas were the view that the untying of investment banks from some of the restraints imposed in the New Deal period was a requirement of competition among large-scale financial firms in the global economy; the New Deal restraints came to be disparaged as burdensome remnants of a bygone era.

Such a haphazard institutional compromise can be hard to change on account of all the powerful interests and prejudices that shield it. Yet, once that shield is punctured, in any direction, by opposing ideas and interests, the compromise can change. Even a partial change can decisively alter the situation and the evolution of finance.

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