Yves Smith brings the same clear and concise writing to ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism, her explanation of the Great Crash of 2008, that she shows every day at her website Naked Capitalism. Smith points to the abject failure of neoclassical economics as the beginning point for this disaster. The unproven assumptions of this theory were converted into Indubitable Truth by academic economists. Their careers were based on their ability to combine those Indubitable Truths with other unproven assumptions and turn them into mathematical formulas which, they said, explained the way the economy works. These ideas were widely accepted by corporate interests and their shills and think tanks, media elites and politicians, and turned into statutes and regulatory policy. Immediately the vipers on Wall Street exploited every one of the new weaknesses for personal profit, first at the expense of other traders, then at the expense of their own clients, and finally at the expense of taxpayers.
Today’s neoclassical economics started with Paul Samuelson, who realized that if he made certain assumptions, he could turn big chunks of economics into mathematical equations, and explain the US economy in a few formulas. One of his simplifying assumptions is that economy is like a pendulum. No matter where it starts, it swings towards a position of equilibrium, a place where no further motion occurs. Fortunately, and amazingly, that equilibrium is at the point of full employment.
Smith explains that this assumption has no basis in reality. Any moderately complex system has feedback loops. Some are negative, that is self-damping, like pendulums. Others are positive. They generate wilder and wilder swings until they disintegrate. It is easy to think of positive feedback loops in the economy. Smith points to the tragedy of the commons, with a real world example of the over fishing of the Great Banks. Throughout the book she describes feedback loops that contradict the equilibrium hypothesis.
She takes up several of the other mainstays of neoclassical economics, including the efficient market hypothesis and rational expectations theory, and their theoretical children, which formed the basis of financial economics. These ideas led to the complex models used by the geniuses on Wall Street. In order to make the math easier, they all assume that randomness in the economy has a Gaussian or normal distribution. The evidence shows that randomness in financial markets is much more complex, and very difficult to compute. She points to a significant economic theorem that mainstream economists had to ignore, the Lipsey-Lancaster theorem. But those annoying reality thingies didn’t stop them. Any theory is better than none, said Milton Friedman, and the equations flowed.
One of the things economists and their corporate cheerleaders have persuaded politicians and media elites to believe (or say they believe) is that all increases in gross national product are good, regardless of any costs not captured in prices, like pollution and bailouts. Therefore any practice that interferes with the workings of the markets is bound to be bad. This position is so ingrained in the political class that it is not possible to discuss any regulation, no matter how crucial, on its merits. Eventually, it led to the destruction of the regulatory framework of the New Deal and into the wasteland we now inhabit.
Smith then turns to a detailed explanation of the tricks and traps used by Wall Street traders and their supervisors. One of those tricks is that profits to be realized in the future were used to compute bonuses. Smith explains:
If you owned a commercial building, had an unbreakable lease to Uncle Sam, and also bought a contract from a AAA-rated insurer to protect you against increases in your operating costs, no one would consider it reasonable to take the future income, deduct the costs of the insurance policy, discount it back to the present day, and record all the income now. Yet banks did something very much like that on a large scale basis, and paid bonuses on those future earnings.
Of course, many of those future profits did not appear, but the traders and their supervisors had pocketed their bonuses and didn’t care.
Banks thought they could protect themselves from market risks by using models based on neoclassical economics. Smith gives us a tour of the failings of those models, and then explains why even the poorly-designed systems were not enforced. Not surprisingly, it involves bonuses to traders.
Smith shows that a credit bubble lies at the heart of the Great Crash. She shows how the shadow banking system aggravated this bubble, and describes the role of credit default swaps in the subprime mortgage/collateralized debt obligation disaster. These explanations are not quick reading, but they are crystal clear on careful reading.
Smith’s analysis of economic theory and the people who tried out their groundless theories on an unsuspecting public is devastating. Her analysis of Wall Street management and traders is equally devastating. Both groups have inflicted huge losses on all of us, but no one from either group has been held accountable.
It is customary in books like these to come up with a set of proposals to fix things. Smith doesn’t believe real reform is possible, so her
… prescriptions [for reform] assume that the supposed representatives of the public manage to free themselves of the corruption of influence by the financial lobby. Should they fail, the looting will continue, as will corrosion of the notion that the United States and other economies with powerful banking interests are indeed nations of laws.
One final thing. Smith begins her acknowledgments section by recognizing the contributions of the commenters at Naked Capitalism. All of the contributors here join that sentiment.