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

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Editorial Article Type: Editorial From: critical perspectives on international business, Volume 5, Issue 1/2 As Critical Perspectives on International Business prepared to enter its fifth year of publication, we found ourselves faced with a situation which was considered by some as the major crisis of the twenty-first century – global financial meltdown. 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 academic Stefano Harney was reported in the Times Higher Education Supplement (Corbyn, 2008) as blaming business academics 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 which would be subject only to editorial review, so that they might appear as quickly as possible and stimulate further academic 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 inclusion in 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 of theoretical perspectives, including institutional theory, systems theory, and political and economic theory. Federico Caprotti’s paper ponders the future role of the state in relation to financial frameworks and leads into the group of empirical 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 variety of financial institutions in the USA, the UK and Brazil. We end the Special Issue with Steven Pressman’s call for a return to the economics of Keynes and Jan Toporowski’s short reflection on the implications of the financial crisis for the field of international business. We hope that this collection will stimulate further discussion in the academic literature, will be found of relevance to those engaged in determining future financial institutional frameworks and practices, and will inform the types of critical management 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

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Why moral failures precede financial crises David Weitzner and James Darroch

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Schulich School of Business, York University, Toronto, Canada Abstract Purpose – This paper aims to explore the linkages between greed and governance failures in both financial institutions and financial markets. Design/methodology/approach – The paper described how innovation changed the US financial system through an analysis of recent events, and employs the philosophic concepts of hubris and greed to explain certain developments. Findings – The development of the shadow banking system and opaque products was motivated in part by greed. These developments made governance at both the institutional and market levels extremely difficult, if not impossible. In part the findings are limited by the current opacity of the markets and the dynamics of events. Practical implications – The implication of the research is to reinforce the need for transparency if the risk of innovation in the financial system is to be both identified and managed. The creation of central clearing houses and/or exchanges for new products is clearly indicated. Originality/value – Understanding the linkages between greed, hubris and governance in the development of opaque products provides insights of value to those trying to understand the current crisis – from academics to practitioners. Keywords Governance, Ethics, Financial markets, Banking, United States of America Paper type Conceptual paper

critical perspectives on international business Vol. 5 No. 1/2, 2009 pp. 6-13 q Emerald Group Publishing Limited 1742-2043 DOI 10.1108/17422040910938640

Introduction Innovation and crises are endemic to the financial system and while every failure leads to significant regulatory improvement, it has never been enough to prevent the next financial 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 without seeing how financial innovation fundamentally changed the financial system of the USA and consequently for those financial systems connected to the USA – essentially the 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 lightly regulated side of the US financial system, where greed was unchecked (Johnson and Neave, 2008). While there was clearly a failure of regulation, it should be first seen as a failure in scope of regulation. But it is equally important to understand how hubris united with greed was instrumental in players working to create an unregulated market. What is stunning about the current crisis is that it is the result of governance failures of both the boards of financial institutions and markets despite significant regulatory reforms in the banking world – Basel II – and corporate governance in the USA – Sarbanes-Oxley (SOX). The lesson to be learned is that regulatory reform without ethical reform will never be enough. The faith that public policymakers had resolved the major economic issues associated with business cycles and volatility combined with the private sector’s faith in hyper-rational modern finance and unregulated markets (Lynch, 2007) created an

environment conducive to the growth of greed. The arrogant faith in the new financial order led to a lack of attention to governance and ethics despite famous ethical failures and heightened regulatory concerns. While it is often said that success breeds success, long bull markets and excess liquidity breed over-confidence and an over-commitment to revenue-generating activities as opposed to control activities. In this environment of weak governance, unethical behavior flourishes. Management scholars have already faced tough questions about the ethical implications of their theoretical suppositions (Ghoshal, 2005), but the current financial woes have led to renewed calls for a more central place for ethical considerations in mainstream management theories along with new questions about the significant role greed and hubris tend to play in the practice of management. We believe that the time has come for researchers concerned with the financial system and the question of ethics to address explicitly the problem of greed. “The Great Moderation”: hubris and the limits of rationality There was a belief that policymakers had created a new and less volatile world. Ben Bernanke in a 2004 speech talked about the new world of the “Great Moderation”: The Great Moderation, the substantial decline in macroeconomic volatility over the past twenty years, is a striking economic development. Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question about which no consensus has yet formed. I have argued today that improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well. Moreover, because a change in the monetary policy regime has pervasive effects, I have suggested that some of the effects of improved monetary policies may have been misidentified as exogenous changes in economic structure or in the distribution of economic shocks. This conclusion on my part makes me optimistic for the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s (Bernanke, 2004).

Unfortunately, the policymakers were not alone in their heightened self-confidence concerning their ability to manage the economy. The massive egos of many leaders, executives and aspiring executives of financial firms also played a role. The popular press abounds with stories of the arrogance of players in the financial world, both real and fictional (Bruck, 1989; Lewis, 1989; Stewart, 1992; Wolfe, 1987). Much of the arrogance is brought about by a blind faith in modern finance and perhaps the likelihood of government intervention if things went wrong. This may have been the lesson drawn by market participants from the 1998 crisis brought about by the hedge fund Long Term Capital Management (LTCM). Despite mounting evidence, the players at LTCM clung to the belief that their models were correct and that what was happening to them could not happen to them (see, for example, Lowenstein, 2000). But at the darkest moment, the Fed intervened, brought together the players, and found a resolution. Nassim Nicholas Taleb’s attacks on the unfounded belief in the new “pseudo science” in Fooled by Randomness (Taleb, 2005), The Black Swan (Taleb, 2007a) and the Financial Times (Taleb, 2007b) clearly demonstrate the need for humility, as well as art in risk management. There can be little doubt but that arrogance led many strictly quantitative financiers to underestimate dramatically the events that were unfolding in front 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 the uncertainty that was in the tail of their distributions. Perhaps one striking event in the current crisis will turn attention from computer screens to reality: The turmoil in financial markets has taken hold of the strategically important trade in long-term interest rate derivative, pushing rates to levels once thought to be a “mathematical impossibility.” [. . .] On Thursday [October 22], the 30-year swap spread turned negative after briefly flirting with such levels earlier in the month. This implies that investors are somehow reckoning that they are more likely to be paid back by a private counterparty than by the government, which can print money (Mackenzie, 2008).

The arrogance born out of a belief in hyper-rational “scientific” models is especially striking given the recognition that modern economics has given to the field of behavioral economics and finance. The Nobel Prize in economics surely conferred intellectual respectability upon the field when it awarded the prize in economics to George A. Akerlof, A. Michael Spence, and Joseph E. Stiglitz for their analyses of markets with asymmetric information in 2001, followed in 2002 with the award to Daniel Kahneman for his seminal work on psychology and economics and Vernon L. Smith for having legitimized laboratory experiments in the field of economics. The evidence was there for all to see that hyper-rationalistic models needed to be applied with caution. The evidence was not only there in theory but in past experience. In remarks concerning the LTCM failure and the Asian Crisis, Federal Reserve Governor Laurence H. Meyer (1999) noted that the correlations among markets behaved differently than expected by the market strategists. The correlation among the markets increased, and consequently heightened rather than lessened the impact of events. The belief in the random behavior of markets blinded market participants to the possibility of systemic issues tied to herd behavior. Yet, in 1841, Charles MacKay published Extraordinary Popular 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 our society to represent a less than virtuous trait (notwithstanding the fact that the “greed is good” mantra, popularized by Oliver Stone’s “Wall Street”, has been adopted without irony by some in the business profession). “Greed” is in essence a rather difficult concept that has engaged thinkers across all religious and philosophical traditions throughout history. In Western society, it is perhaps most notably associated with the seven deadly sins of the Christian faith, but Tickle (2004) notes Hindu, Buddhist, Taoist, Sikh, Muslim and Jewish sources which supports her assertion that every system 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 immorality and explains how traditional Judaism limits the harmful effects of greed through a divinely revealed code that provides a normative economic morality. In the Jewish tradition, economic activity and the acquisition of wealth can be viewed as virtuous

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 an intellectual and moral disdain for greed in all of its manifestations. Bragues (2006) has recently reminded business ethics scholars of the potential for Aristotelian virtue to inform our current debate on the place for greed in the practice of business. Generosity and magnificence are two virtues discussed by Aristotle and reinterpreted by Bragues (2006) that encourage morally minded individuals to pursue capitalist interests and even 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 individual manager 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 like greed, virtues represent the best in us and our communities, and the drive to excel for reasons that go beyond the simple pursuit of profit represents the most elementary of virtues appropriate to the discipline of management. For this paper, we wish to propose a working definition of greed that is rooted in economic behavior while embracing a moderate position closest in spirit to the Jewish and Aristotelian traditions that view greed as a vice only to the extent that it serves to hamper the positive possibilities of economic exchange. We propose that greed in this context needs to be viewed as occurring in situations where an individual seeks an economic return of greater value that what her input should reasonably earn and in so doing imposes costs upon others. The other is harmed in this process because the other’s ability to claim fair value is oppressed. In the context of the firm operating in society, greed is encountered when a firm attempts to avoid paying the full costs for its behavior (what economists call externalities). The pursuit of economic rents can therefore be virtuous provided that the economic actors respect the notion of mutually beneficial exchange as the ethical core of economic activity. Virtuous management involves a delicate balancing act between seeking out and developing innovative techniques and behaviors while at the same time keeping these innovations in check to ensure that they are conforming to society’s norms of ethical behavior. Financial innovations in particular can bring about significant and tangible social good in spurring economic innovation. For example, innovations in the financial markets have resulted in popular mechanisms that allow for houses to be made more affordable to the average family. However, these same financial innovations that offer opportunity for the average individual also have the capacity to tempt investors into irresponsible 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 or to gamble recklessly in the pursuit of high returns. In an ethical sense, financial innovation increases our opportunities to act as prudent, caring individuals, limiting harm to stakeholders such as employees, customers, and shareholders. But derivatives also create the opportunity to gamble on a massive scale. What this means is that even if the financial innovations are ethically neutral, the actions of the economic actors employing these innovations are not. If we cannot or do not wish to limit financial innovation then we must be fundamentally concerned about the moral character of those in the vanguard of poorly understood innovations. While economists and regulators may focus on the knowledge problem, it is just as important to 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 this context it may be useful to recall the desire expressed in the Lord’s Prayer: “Lead us not into temptation”. It is critical for management scholars concerned about ethics to understand the implications of the structural changes in the financial sector and to further understand that in many cases the only safeguard is the moral character of the financiers.

10 The new world of banking: “the shadow banking system” While greed is a constant in human behavior it is important to recognize how the financial world changed and created new opportunities for avarice that had systemic implications. William R. White (2004) at the Bank for International Settlement has written of the phenomena of “marketization”: the growing importance of financial markets compared to traditional financial institutions (e.g. banks). We need to realize the radical shift that has taken place in financial systems concerning credit facilities and risk transfer. The primary source of debt for firms has become the markets – or the “shadow banking system” as it has become known, and this has transformed the world of credit risk management (Rowe and Day, 2007). Moreover it is outside of US regulation. Christopher Cox, Chairman of the SEC, testifying to the Senate Banking Committee on September 23, 2008, made clear the role of lack of regulation in the current financial crisis: The failure of the Gramm-Leach-Bliley Act to give regulatory authority over investment bank holding companies to any agency of government was, based on the experience of the last several months, a costly mistake. There is another similar regulatory hole that must be immediately addressed to avoid similar consequences. The $58 trillion notional market in credit 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 require minimal disclosure to the market (see www.sec.gov/news/testimony/2008/ts092308cc.htm).

Former Federal Reserve Chairman Alan Greenspan, testifying before the House Committee of Government Oversight and Reform, confessed that he had counted upon the self-interest of financial institutions to protect shareholder equity. It should be noted that such a faith in market governance was not without support. The failure of the hedge fund Amaranth in September 2006 was in many ways a precursor to the current wave of financial failures, yet it caused no such systemic problems. Amaranth was trading futures on an organized exchange where the exchange was the counter-party to Amaranth’s contracts. As Amaranth started to get in trouble, the exchange forced the sale of Amaranth’s contracts in a liquid market to maintain its margin position (Cecchetti, 2007). As a result of these forced sales, while Amaranth failed and its shareholders lost, there were no systemic problems. The exchange had the information and ensured that market governance worked. In governance terms, Amaranth’s transactions were transparent to market participants. Such is not the case with many of the innovations in what has come to be called the “shadow banking system”: A plethora of opaque institutions and vehicles have sprung up in American and European markets this decade, and they have come to play an important role in providing credit across the financial system. Until the summer, structured investment vehicles (SIVs) and collateralised debt obligations (CDOs) attracted little attention outside specialist financial circles. Though often affiliated to major banks, they were not always fully recognised on

balance sheets. These institutions, moreover, have never been part of the “official” banking system”: 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 causes of the turmoil is that parts of this hidden world are imploding. This in turn is creating huge instability for “real” banks – not least because regulators and bankers alike have been badly wrong-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 Pimco asset 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 and mystically create and then package subprime loans in [ways] that only Wall Street wizards could explain.” (Tett and Davies, 2007).

We wish to call attention to one particular aspect of this “unregulated” market: its opaqueness. 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 is no 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 by the participants. Participants could have chosen to create from the start the clearing houses and even exchanges that they are now considering (The Economist, 2008; Tett et al., 2008). This would have made this market far more transparent. Yet, ignoring the potential risks of opaque markets, the participants opted for opacity. The opacity meant that even market participants were functioning in a world where the lack of information made it impossible to assess accurately the full credit risk of counter-parties and there was no mechanism to buffer mistakes. The merger of the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT) hoped to challenge the OTC markets and become the clearing house for all on-exchange derivatives and move into the OTC market with its own products. Not surprisingly this has met with the opposition of major banks, which control 85 percent of global derivatives trade (Cameron, 2007). The response of the banks was to be expected – all firms seek to protect their profitability – but in this case, the greed for private profits led to extremely high public costs. Greed overrode considerations of creating the appropriate infrastructure of information disclosure necessary to ensure market governance. Interestingly, if market governance couldn’t work, neither could firm governance, since there was inadequate information on the positions taken by individual players. It should further be recognized that the many of the problems in the subprime mortgage market were also tied to improper governance related to lower levels of screening for securitized products (Keys et al., 2008). Conclusion The blind faith in markets being able to count upon self-interest to ensure self-regulation ignored major advances in the field or economics. Self-interest may well have guided actions but it was the form of self-interest which is at the heart of agency problems. It seems reasonably clear that while the shareholders were wiped out, many players at the institutions were considerably enriched during the process – even with golden parachutes. While there may be problems in implementing controls on executive compensation, it is hard not to believe that devastated shareholders are entitled to a certain level of righteous indignation. We believe that it is correct to believe 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 to demonstrate how isolated insiders of the financial community had become to broader concerns. The “shadow banking system” was a governance failure waiting to happen. First, how could the governance structures at firms such as Lehman have measured their exposure to credit risk given the lack of information decried by Cox? Clearly the boards of the banks were not performing the oversight role that they owed to their shareholders. The failure of many institutions has once again revealed the governance problems that both SOX and Basel II sought to correct. The decision to opt for opaque markets was a strategic decision with serious consequences. Secondly, free market advocates must recognize that in order for free markets to function, there must be open disclosure of information. Market governance is impossible in the absence of relevant information. The immediate challenge is to restore trust not only among financial institutions to restore the inter-bank markets, but also trust from the public. This is a tall order. Greed led 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 order to ensure that they could create wealth for themselves while improving the lot of others failed to recognize this obligation. Rather, greed and hubris led to the enrichment of the few to the cost of the many. It would be naive to believe that a moral renaissance is at hand and will solve all ills, so until that time we must enforce rules to promote the virtue 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 Economic Association, 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 Junk Bond 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 new context”, Management Research News, Vol. 31 No. 1, pp. 12-26. Keys, B.J., Mukherjee, T., Seru, A. and Vig, V. (2008), “Securitization and screening: evidence from 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 Paper No. 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, New York, NY.

Lowenstein, R. (2000), When Genius Failed: The Rise and Fall of Long-Term Capital Management, Random House, New York, NY. Lynch, J.T. (2007), “Credit derivatives: industry initiative supplants need for direct regulatory intervention: 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, Wilder Editions, 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 Bank of Chicago, Chicago, IL, October 1. Rowe, D.M. and Day, T. (2007), “Credit risk management’s 25 year transformation”, The RMA Journal, 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 contemplates a more fettered future”, Financial Times, September 30. Tickle, P.A. (2004), Greed: The Seven Deadly Sins, Oxford University Press, Oxford and New York, NY. White, W.R. (2004), “Are changes in financial structure extending safety nets?”, BIS Working Paper 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 authors David Weitzner is a Sessional Assistant Professor of Strategic Management at the Schulich School of Business and Associate Director of the School’s Strategy Field Study Program. His major research interest is in exploring the relationship between strategic activities and ethical virtues. James Darroch is an Associate Professor of Strategic Management at the Schulich School of Business and Director of the School’s Financial Services Program. His major research interest is the strategic management of financial institutions with a particular focus on the relationship between enterprise risk management and strategy. He has worked with several large financial institutions. James Darroch is the corresponding author and can be contacted at: jdarroch@ sympatico.ca or [email protected]

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Paper assets, real debts An ecological-economic exploration of the global economic crisis

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Giorgos Kallis ICREA and Institut de Cie`ncia i Tecnologia Ambientals (ICTA), Universitat Auto`noma de Barcelona, Barcelona, Spain

Joan Martinez-Alier Departament d’Economia i d’Histo`ria Econo`mica and Institut de Cie`ncia i Tecnologia Ambientals (ICTA), Universitat Auto`noma de Barcelona, Barcelona, Spain, and

Richard B. Norgaard Energy 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 field of ecological economics to the explanation of the current economic crisis. The root of the crisis is the growing disjuncture between the real economy of production and the paper economy of finance. Design/methodology/approach – The authors trace the epistemological origins of this disjuncture to 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 and discursive processes for understanding and engaging with ecological-economic systems. Originality/value – The authors embrace the notion of sustainable de-growth: an equitable and democratic transition to a smaller economy with less production and consumption. Keywords Economic depression, Recession, Ecology, Economic theory Paper type Conceptual paper

Benjamin M. Friedman, author of The Moral Consequences of Economic Growth, recalled that when he worked at Morgan Stanley in the early 1970s, the firm’s annual reports were filled with photographs of factories and other tangible businesses. More recently, Wall Street’s annual reports tend to highlight not the businesses that firms were advising so much as finance 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 become further and further divorced from actual economic activity.” Which might serve as a summary of how the current crisis came to pass. Wall Street traders began to believe that the values they had assigned to all sorts of assets were rational because, well, they had assigned them (David Leonhardt, New York Times, 21 September 2008). critical perspectives on international business Vol. 5 No. 1/2, 2009 pp. 14-25 q Emerald Group Publishing Limited 1742-2043 DOI 10.1108/17422040910938659

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. [. . .] And ascribing independent reality to what you have in fact made yourself is a perfect definition of what the Jewish and Christian Scriptures call idolatry (Rowan Williams, Archbishop of Canterbury, The Spectator, 24 September 2008).

Immediate explanations pointing to proximate causes of the current financial crisis dominate public discourse: the greedy bankers, the bad loans, the unregulated financial products or the collapse of the housing market. Instead, we engage with the structural causes of the crisis. The uneven temporal and spatial pattern of capital accumulation has – deservedly – received much attention as a structural cause of the cyclical repetition of economic crises. But less attention has been paid to ecological and resource factors. This paper highlights some key ecological-economic insights concerning the current economic crisis. We argue that: . at the roots of the crisis is the growing disjuncture between the real economy of production and the paper economy of finance; . the costs of the financial crisis pale in comparison to those of current and forthcoming ecological crises; . the myths of economism – a mix of academic, popular and political beliefs that serve to explain and rationalise the economic system – allowed and justified the disjuncture between real and paper economies; and . the current crisis provides opportunities at an epistemological level, to escape from economism and at the practical level, to promote alternative socio-economic paradigms 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 economy The field known as ecological economics (EE) was born out of the dissatisfaction of economists and natural scientists with the treatment of environmental issues by mainstream economics. Today EE involves a diverse field of researchers united by an ambition to reclaim the classical economic tradition of putting nature as a key factor in economic analysis. One might distinguish between a more conservative line of EE which accepts the basics of neoclassical economics but works to couple better economic with ecological models and a more critical, political-economic line of research, to which the authors of this paper belong, which seeks new paradigms for understanding ecological-economic systems as a whole and emphasises distributional, institutional and power issues (Spash, 1999). Georgescu-Roegen’s (1971) seminal critique of economics based on the laws of thermodynamics and in particular entropy and the distinction 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 activity and Karl William Kapp’s (1970) reframing of environmental externalities as the pervasive 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 rejects the rational, “homo-economicus” assumptions of mainstream economics and their liberal-utilitarian normative counterpart, which privileges market and cost-benefit mediations of human wants. Multiple, incommensurable values are recognised and deliberative-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 society where 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) and fundamentally as hiding the social – environmental and distributive – costs of economic expansion (Martinez-Alier, 2002). From an EE perspective, externalities are not accounting problems, but social cost-shifting successes predicated upon institutional and power inequalities that allow some peoples’ values to count and others’ not (Martinez-Alier, 2002). But how is all this relevant to the present crisis? Real wealth versus paper wealth Rather than focusing on the immediate level of finance, from an EE perspective the economy must be analysed at three levels. At the top there is the financial level that can grow by loans made to the private sector or to the state, sometimes without any assurance of repayment as in the present crisis. The financial system borrows against the future, on the expectation that indefinite economic growth will give the means to repay the interests and the debts. Then there is what the economists describe as the real economy, the GDP at constant prices. When it grows, it indeed allows for paying back 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-real economy, the flows of energy and materials whose growth depends partly on economic factors (types of markets, prices) and in part from physical and biological limits. The real-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 too fast and too large for the real economy beneath to catch up. Frederick Soddy, a Nobel Prize winner in Chemistry, had made this point in his book Wealth, Virtual Wealth and Debt (Soddy, 1926) published in 1926 (Martinez-Alier, 1990). Soddy argued that it is easy for the financial system to increase the debts (private or public debts), and to mistake this expansion of credit for the creation of real wealth. However, in the industrial system, growth of production and growth of consumption imply growth in the extraction and final destruction of fossil fuels. The obligation to pay debts at compound interest could be fulfilled by squeezing the debtors for a while. Other means of paying the debt are either inflation (debasement of the value of money), or economic growth – which is falsely measured because it is based on undervalued exhaustible resources and unvalued pollution. According to ecological economist Herman Daly, the current crisis is due to the overgrowth of financial assets relative to the growth of real wealth; there is too much liquidity, not too little. “Paper exchanging for paper is now 20 times greater than exchanges of paper for real commodities” (Daly, 2008). As a consequence the value of present real wealth is no longer sufficient to serve as a lien to guarantee the exploding debt and debt is being devalued (Daly, 2008). Can the real economy catch up with debt? Ecological economists have argued with neo-classical economists whether continuous growth is possible (see Ecological Economics, Vol. 22), let alone desirable. Ecological economists have scrutinised the optimistic assumption of neo-classical economists (and most Marxists as well) that

resource substitution and technological innovation will always surpass biophysical limits (Daly, 1991). This is not to posit a simplistic notion of absolute bio-physical limits to growth, but to take seriously the possibility that the depletion of stock resources, the degradation of “sinks”, such as the global atmosphere and the increasing occupation of Earth’s space, may limit the continuous expansion of the scale of the economy and condition future human activity decisively (Norgaard, 1994). Adaptation to the changing environmental conditions may not be gradual or reversible: resources, sinks and ecosystems have thresholds which, once surpassed, lead to dramatic and very fast changes. Humans may adapt to whatever the future might bring, but the question is how many will survive and which, at what level of subsistence they will live, and what pain will be suffered along the way. Bio-physical constraints and the bottom level of the economy condition the rate at which real wealth can increase. In addition to financing and housing, high oil prices also triggered the present crisis. These were due not only to the OPEC oligopoly and oil market speculation but also due to the approaching peak-oil (Deffeyes, 2001) and market expectations of it. Also while in the 1920s the price of commodities decreased for a few years before 1929, this time the increase in commodity prices (also driven by the misguided subsidies to agri-fuels) continued for some months after the strong decline in the stock exchange started in January 2008. In late 2008 the prices of oil and commodities were declining, but this is because of declining demand, not increasing supply. 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 of its fair inter-generational allocation and the externalities it produces. As the crisis deepens, the price of oil goes down but it will recover in real terms if and when the economy grows again. Declining prices will cause some expensive sources to stop production (Alberta oil sands, for instance) and will also lead to lack of investment in new extraction sites. OPEC will try and reduce oil extraction during the crisis. The scheduled 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 (aided by speculation in the futures market), then this will make economic recovery more difficult. Peak-oil does not mean immediate scarcity. It means that it is less easy to find oil 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 a declining rate. We are not sure, however, whether we have already passed the peak or not, and we cannot be certain about the economics of other energy sources. This means that 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 fact remains that there is no way the economy can grow fast enough in real terms to redeem the massive increase in debt (Daly, 2008). As Daly (2008) argues, “spatial displacement of old stuff to make room for new stuff is increasingly costly as the world becomes more full, and increasing inequality of distribution of income prevents most people from 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 gas emissions will have such catastrophic impacts that will more than offset any growth (Intergovernmental Panel on Climate Change, 2007). Wishful thinking about de-materialised growth has proven elusive (Martinez-Alier, 2002; Polimeni et al., 2008).

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The real toxic debts The assets that take the form of claims to debts that will remain unpaid have been given the funny name of “toxic assets”. But what about the liabilities, like the enormous “carbon debt” that is owed to future generations, and to the poor people who have produced little greenhouse gases (Srinivasan et al., 2008)? Large environmental liabilities are due by private firms. Chevron-Texaco is being asked to pay back 16 billion dollars in a court case in Ecuador. The Rio Tinto company left behind large liabilities since 1888 in Andalusia where it got its name, and also in Bougainville, in Namibia, 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 Niger Delta. These real poisonous debts are in the history books but not in the accounting books. New fossil fuels and mineral sources have a low EROI (energy return on investment) and high marginal costs. Diplomatic and military pressure on the exporting countries intensifies; although the rate of oil extraction could still increase somewhat, 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 the economic costs from global ecosystem degradation and climate change (Millennium Ecosystem Assessment, 2005; Intergovernmental Panel on Climate Change, 2007) will be an order of magnitude higher than the accumulated debt that belies the present crisis. 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 the one that belies the present financial crisis: commodify unpriced ecological goods and let the free markets regulate their provision without state intervention. Karl Polanyi (1944), in The Great Transformation, saw the parallels between the deregulation of money supply and the commodification of nature and the double danger these posed. Money and nature (alongside labour), he argued, are fictitious commodities, that is things that circulate in the market as though they are commodities originally produced for it, when clearly they are not. Like Polanyi, many ecological economists have insisted on the impossibility and undesirability of nature’s commodification (Vatn and Bromley, 1994). But such voices are against the current: new fictitious markets, from trading carbon to pollution permits, water rights or payments for ecosystem services, are increasingly imagined and enacted (Kosoy, 2008). The risks of linking the value and level of protection of ecosystem services to the ups and down of markets and currencies go unnoticed (Harvey, 1996; Kosoy, 2008). To understand how these myths of self-regulating markets, perpetual growth and the disjuncture of the fictitious, paper economy from the real economy came to be, we need to turn to the realm of ideas and their interaction with politics and economics. The myths of economism Let us distinguish between an economy that is “out there” and the complex of myths that people, both individually and in order to act together, have developed to aid them in living within the economy. This distinction is roughly parallel to nature as a reality of its own and the complex of myths traditional peoples hold about nature and their relation to nature. In traditional societies, myths provide explanations for natural phenomena, facilitate individual and collective decisions, and give meaning and coherence to life. As people act on their myths, their societies and the natural

environment are shaped and co-evolve around them. Today, as we act on scientific understandings that were first mechanical, then chemical, and more recently biological, we see agricultural soils and rural communities transforming and co-evolving with the path of science (Norgaard, 1994). As modern people, we also act on comparable beliefs about our world (a world that is largely economic), that are rooted in the discipline of economics. We refer to this complex of myths as economism, and like traditional beliefs and scientific understanding, economism explains phenomena, facilitates individual and collective decisions, and gives meaning and coherence to our lives. Similarly, our economy is driven by and coevolves around economism. With a 25-fold increase in global market activity during the twentieth century, the economy became the cosmos of roughly half the world’s people. The rise of the market economy in everyday life, with exchange occurring over ever greater distance, can be thought of as a wedge between our contact with nature and with the moral consequences of the decisions we make. The growth of the economic cosmos is both facilitated and rationalised in public discourse by economic reasoning, albeit typically quite simplified. Simplification is also key to the dominant approach of rational thinking and the nature of disciplines. The history of scholarly economic thought can be understood as a process of boundary keeping, a process of rationalising arguments that either ignored entirely or entailed gross simplifications about the natural world and broader questions of right and wrong. Increasingly, modern people, few of whom are trained in the natural sciences, must peek through the economy to see how we relate to the natural world. Economists have pioneered and encouraged this approach. Barnett and Morse (1963) provide a clear example of trying to understand the state of nature and our relation to it through the economy. They argued that resources could not possibly be scarce because resource prices declined from the late nineteenth century through much of the twentieth. Rising prices indicate resource scarcity whether simply thinking in terms of supply and demand between two periods, using Ricardo’s argument about how the best land is used first, or exploring Hotelling’s far more sophisticated model of optimal resource use 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 resource prices have been falling, resources cannot be scarce. But the minor premise of their own argument, the part that connects economics to reality, has been forgotten. If market participants do not know resources are scarce in some real sense, the economic argument is invalid. If they do know, we should simply ask them. Surely it is better to learn from the differences in understanding between participants and thereby learn about the risks and conditions under which their understandings are more likely true. Prices simply blend the complexities of their understanding to a single directional indicator with no other information (Norgaard, 1990). The critically important point, however, is that for markets to work well, sufficient market 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 presumption explains how trouble arose in the USA through the housing market. Judging reality through the market, home buyers and banks were confident that housing prices would continue to go up because housing prices had “always” gone up. Lenders made loans to home owners whose abilities to pay were marginal and contingent upon both a healthy economy and their beliefs that home prices would always rise. Lenders knew that these new home owners might not be able to make their mortgage payments, but this was not seen as a problem because the banks thought they would simply be left holding an asset whose value was still greater than the mortgage that remained to be paid. Then Wall Street investment banks repackaged the risky mortgages as equities, portraying them as hot stocks in a rising market. The mass deception worked, indeed the increased perception of wealth helped drive up home prices by adding to the demand for homes. Everything was going up until energy prices also went up and the economy began to be less healthy. Mortgage payments were not made, banks foreclosed, but as they did so in increasing numbers, housing prices dropped, and the assets of the banks became “toxic”. The problem was that all the actors in the process had been looking at what they thought was reality through trends in market signals rather than looking at the underlying reality. For the same reasons that the financial crisis arose, managing it is difficult because economic actors are looking at crashing equities prices rather than underlying real conditions, which surely have not changed that drastically, and as they do, the market crashes ever more rapidly in a self-fulfilling prophecy. When we do try to assess the underlying ecological basis of our economy, the situation looks very bleak. By a fairly simple measure, the ecological footprint, the global population needs to reduce consumption by 25 percent to consume and process our wastes sustainably (Wackernagel et al., 2002). The assessment by the Intergovernmental Panel on Climate Change (2007) indicates that we need to reduce greenhouse gas (GHG) emissions by 80 percent globally by 2050 to avoid harmful, if not catastrophic, climate change. Hansen et al. (2008) argue that we have already passed the point of catastrophic climate change and need to reduce the existing level of GHGs 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 in human well-being and economic development, but these gains have been achieved at growing costs in the form of the degradation of many ecosystem services, increased risks of nonlinear changes, and the exacerbation of poverty for some groups of people. These problems, unless addressed, will substantially diminish the benefits that future generations obtain from ecosystems.

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

Beyond economism We need to put much more effort into being informed of underlying conditions for markets to work well, and this is both more critical and difficult when markets entail great distances and complex transactions. How can a society taking advantage of the gains from specialisation and exchange, a process that wedges people apart from reality and the moral implications of their decisions, be both informed and moral? One answer is clearly that being informed and moral are necessary for market stability, sustainability and justice, and put some serious limits on the optimal extent of exchange (Norgaard and Liu, 2007; Norgaard and Jin, 2008). While economists are fond of noting that there are always tradeoffs and optima, one of the myths of economism has been that expanding the extent of trade is always good. There are costs to expanding markets that offset the benefits, and optimal markets may be quite constrained compared to those of today. To be better informed of reality and more moral, we probably need to deliberately set up some new institutions to facilitate these goals. The Millennium Ecosystem Assessment (MA) proved to be an interesting example of a collective process for assessing reality, discussing morality, and confronting economism (Norgaard, 2008). Some 1,400 scientists from around the world participated in a review and evaluation of the existing literature on the status and importance of ecosystems and their services and the drivers forcing their degradation. Participants from developing countries repeatedly pointed out that the values of environmental services as determined through market prices or behavior were heavily weighted by who had the income to pay for them. The prices of ecosystem services reflected the tastes and concerns of the rich more than the poor. The dollars of rich ecotourists spent on international airfares are weighted the same as the dollars of the poor spent on bus fares to get to work. Thus MA participants readily saw how markets to save trees to sequester carbon, for example, are being established in poor nations where the poor are “willing” to stop using forests because the rich have the economic power to buy up the rights of the poor to 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 using their forests for little. Once this was made clear within the MA process, it was very difficult to use prices generated in markets as neutral values. In short, the open participatory process of the MA began to deconstruct economism (Norgaard, 2008). Another major contradiction of market-based valuation appeared in the Millennium Ecosystem Assessment. Several scientists noticed that for there to be any rationality to relying on stated preferences or behaviour to derive the values of environmental services, one would have to assume that lay people were sufficiently informed of the very ecological complexities the MA scientists were struggling to understand. This assumption contradicted the objective of the MA to provide much needed knowledge to the public and policymakers. In short, as with the problem of measuring resource scarcity by looking at prices over time (Norgaard, 1990), the problems of using monetary values to weight ecosystem services are tightly embedded in the very socioeconomic system driving the problems of ecosystem degradation the MA sought to understand in order to design better socioeconomic policies. This circularity highlights how difficult it is to understand nature without looking through the economy 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 moral discussions. The experience that Pavan Sukhdev (with Haripriya Gundimedia and Pushpam Kumar) gained in India trying to give economic values to non-timber products from forests, and to other environmental services (such as carbon uptake, water and soil retention), has been an inspiration for the Economics of Ecosystems and Biodiversity (TEEB) process sponsored by DG Environment of the European Commission. As the TEEB team states, a monetary representation of the services provided by clean water, access to wood and pastures, and medicinal plants, does not really measure the essential dependence of poor people on such resources and services. In their project “Green Accounting for India” they found that the most significant direct beneficiaries of forest biodiversity and ecosystem services are the poor, and the predominant impact of a loss or denial of these inputs is on the well-being of the poor. The poverty of the beneficiaries makes these losses more acute as a proportion of their “livelihood incomes” than is the case for the people of India at large. Hence the notion of “the GDP of the poor”: for instance, when water in the local river or aquifer is polluted because of mining, they cannot afford to buy water in plastic bottles. Therefore, when poor people see that their chances of livelihood are threatened because of mining projects, dams, tree plantations, or large industrial areas, they complain not because they are professional environmentalists but because they need the services of the environment for 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 other fora that bring people together to debate underlying conditions and appropriate collective behaviour. We need to expand these and enter into them with a larger perspective on their role in offsetting the simplicities of economism. Beyond growth The economic crisis will reduce CO2 emissions and it might slow down the accelerating route to biodiversity destruction and climate change. On the other hand, it might also lead to the reduction of public and private expenditure on green technologies or pollution control. There is no doubt also that recession will hit lower-income groups and countries unevenly. But the problem with the above framing is that it is still couched in the terms of economism and growth. There is a sense of de´ja` vu with the interest rate debate (where high interest rates are supposed to make environmentally destructive 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 are false dilemmas. What we need is an altogether different vision and framing along the lines of an Aristotelian buen vivir (as the World Social Forum proclaims) guided by oikonomia rather than chrematistics. Here we emphasise the transformative potential of an economic crisis, a crisis that many ecological economists said would come sooner or later given the unsustainable pattern of capitalist growth. Now it is the moment to generate new social visions of living well and being happy without the imperative of economic growth. Visions that render compatible living well, working satisfactory and maintaining our local and global ecosystems.

The concept of de´croissance soutenable, or socially sustainable economic de-growth, which Georgescu-Roegen started 30 years ago, is relevant (Latouche, 2004). De-growth is not about decreasing GDP because we might always change accounting conventions and include in GDP other items (unpaid domestic and voluntary work) and deduct the negative externalities of biodiversity destruction, climate change, loss of human cultures. Sustainable de-growth is about creating an alternative, smaller economy, suitable to the physical needs of humans and ecosystems. With the economic crisis, la de´croissance est arrive´e in Europe, the USA and Japan. This is an opportunity for moving with the socio-ecological transition. The challenge is how to manage the transition to a smaller economy in a socially equitable way, where those that levy the greater burden are those that already “have” and who benefited the most from the past pattern of unsustainable accumulation. At first sight, Southern countries have something to lose and little to gain from de-growth in the North: fewer opportunities for commodity and manufactured exports, less availability of credits and donations. But, the movements for environmental justice and the “environmentalism of the poor” of the South are the main allies of the sustainable de-growth movement of the North. These movements 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 and Raubwirtschaft, i.e. ecologically unequal exchange, destruction of nature and human livelihoods at the “commodity frontiers”. They claim the socio-environmental liabilities of transnational companies (Martinez-Alier, 2002). Their objectives are to have an economy that sustainably fulfils the food, health, education and housing needs for everybody. This transition to a smaller, human and ecological-scale economy is not easy. The question is how to manage it smoothly and redistribute its costs to those that most benefited by the unsustainable path that brought us here. De-growth is not apolitical. It calls for a radically new polity with a redistribution of political and economic 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, Johns Hopkins 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, Princeton University 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 University Press, 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 should humanity 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 Physical Science 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, Basil Blackwell, Oxford. Martinez-Alier, J. (2002), The Environmentalism of the Poor: A Study of Ecological Conflicts and Valuation, Edward Elgar, Cheltenham. Martinez-Allier, J., Munda, G. and O’Neill, J. (1998), “Weak comparability of values as a foundation 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 of Environmental Economics and Management, Vol. 19, pp. 19-25. Norgaard, R.B. (1994), Development Betrayed: The End of Progress and a Coevolutionary Revisioning 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”, Ecological Economics, Vol. 66 No. 4, pp. 638-52. Norgaard, R.B. and Liu, X. (2007), “Market governance failure”, Ecological Economics, Vol. 60 No. 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 the Myth 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”, Environmental Values, 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 of ecological impacts from human activities”, Proceedings of the National Academy of Sciences, Vol. 105 No. 5, pp. 1768-73. van den Bergh, J.C.J.M. (2006), “Abolishing GDP: the largest information failure in the world”, working paper, Department of Spatial Economics, Free University, Amsterdam.

Vatn, A. and Bromley, D.W. (1994), “Choices without prices without apologies”, Journal of Environmental 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 ecological overshoot of the human economy”, Proceedings of the National Academy of Sciences, Vol. 99, pp. 9266-71.

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25 About the authors Giorgos Kallis is an ICREA fellow at the Autonomous University of Barcelona. He previously held an EC Marie Curie Outgoing Fellowship at the University of California at Berkeley. He researches the co-evolution of ecological-economic systems, environmental justice and adaptation to climate change. Giorgos Kallis is the corresponding author and can be contacted at: [email protected] Joan Martinez-Alier is Professor at the Department of Economics and Economic History, at the Autonomous University of Barcelona. He is among the founders and a former president of the International Society for Ecological Economics. His current research focuses on ecological economics and languages of valuation, political ecology, environmental justice and the environmentalism 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 constructive critique of neoclassical economics, and is among the founders and a former president of the International Society for Ecological Economics. His current research stresses how scientists collectively and discursively understand complex systems and the implications of this for democracy and ecological governance.

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The global financial crisis: an institutional theory analysis

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Faculty of Business and IT, University of Ontario Institute of Technology, Oshawa, Canada

Suhaib Riaz

Abstract Purpose – This paper seeks to provide insights into the current global financial crisis from an institutional theory perspective. Design/methodology/approach – The paper presents the development of key concepts using institutional 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 is key to understanding the creation of the crisis. Research limitations/implications – The treatment is brief but serves to provoke further research on the global financial crisis through applying and extending new institutional theory. Practical implications – Fundamental aspects of the crisis need to be understood with respect to the organizational-institutional interplay involving the financial industry. This would help to reveal the general pattern of such crises and also point towards what needs to be taken into account for potential solutions. Originality/value – The paper has value for researchers as it opens up a discussion of the current crisis from an institutional theory perspective. Fresh concepts introduced here could be extended further and inform institutional theory in general. The paper has value for policy makers and practitioners in helping them understand the fundamentals of the organizational-institutional interplay underlying the current crisis. Keywords Recession, Financial institutions, Organizational structure Paper type Viewpoint

critical perspectives on international business Vol. 5 No. 1/2, 2009 pp. 26-35 q Emerald Group Publishing Limited 1742-2043 DOI 10.1108/17422040910938668

1. Introduction The current economic crisis, rapidly gaining ground across the world everyday, has been appropriately labeled as a “global financial crisis”. News stories focus on the collapse of banks and financial services organizations that until recently were deemed to be very successful and highly legitimate businesses. How could such successful businesses suddenly collapse and lose all legitimacy? How could the entire industry of investment banking lose legitimacy to the point where popular financial media report on the embarrassment of investment bankers at dinner parties? While the current crisis has several aspects that can be understood using various disciplines and theoretical lenses, new institutional theory (DiMaggio and Powell, 1983; Meyer and Rowan, 1977) can provide a unique perspective for understanding key aspects of the organizational-institutional interplay in the unfolding of the present crisis. In some ways, this situation is not new, and similar elements have been witnessed 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 and Entrepreneurship and at the Academy of Management OMT division for feedback on concepts presented here, with special thanks to Dr Richard Scott for feedback and encouragement.

these crises in a broader manner with theoretical insights that draw out the general pattern. Theoretical insights grounded in a discussion of the current global financial crisis can therefore provide a unique opportunity in understanding the fundamentals of such 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 formal and informal institutions. Such an examination requires understanding the mechanisms of organizational-institutional interplay that follow from basic tenets of new institutional theory. In this position paper, I draw upon the formal theoretical apparatus of new institutional theory and extend its core ideas to help explain the unfolding of the present crisis. 2. Institutional theory and the crisis: a view of the iron cage, inside-out In this section, I present theoretical arguments to throw light on the interplay of financial 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 services organizations comprising the finance industry as organizations that exist within the wider framework of formal and informal institutions. I focus specifically on the US context, though the ideas extend to several affected regions of the world. The formal regulative institutions (Scott, 2001) include the central bank – The Federal Reserve, The Treasury and The Securities and Exchange Commission (SEC) – while the informal normative and cultural-cognitive institutions (Scott, 2001) include the cultural acceptance of debt, high mortgages, disregard for savings, and an aggressive investment-oriented culture that involves even pension funds and 401K accounts as active investors in high-risk equity and debt securities. The new institutionalism has, as one of its core defining symbols, the “iron cage” of homogenization put forward by DiMaggio and Powell (1983), building on Weber’s idea of the iron cage of bureaucratization. In this perspective, organizations are viewed as “imprisoned” by institutions through the powerful processes of institutional isomorphism. While this visual is apt in describing the influence that the institutional environment has on organizations in general, this is only half the picture. The flip side to this is a view of the iron cage inside-out, that reveals the prominent role organizations have in influencing institutions. While the functioning of institutions and their influence on organizations has been much explored, the processes of creation, maintenance, demise and death of institutions have only recently received some attention. This theoretical problem has been described as a concern with the silences of institutional theory, rather than a rejection of its core tenets (Brint and Karabel, 1991). Half of a full sociology of institutions is thus a work in progress, and is key to understanding situations such as the current financial crisis. The need for work in this area has been highlighted by prominent proponents of institutional theory (DiMaggio and Powell, 1991), and recently, several attempts have been made to cover this 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 inform our understanding of the complexities of organizational-institutional interplay in contexts such as the present crisis. However, several of these ideas have been alluded to in empirical works but have not been brought together through theoretical development that would help us understand the issues in an integrated manner. Here I draw upon and extend these ideas to help us understand the unfolding of the current financial crisis. In the sections below, I present key concepts, such as “reverse-legitimacy”, “illegitimate structures” and “institutional crisis”, that extend and integrate some of this emerging work and are particularly useful for understanding the current crisis from a theoretical perspective. That organizations themselves can be the means, and organization-institution interactions be the processes through which power and interests are made to bear upon institutions (e.g. Greenwood and Suddaby, 2006; Garud et al., 2002) is a particularly useful view for understanding the creation and maintenance of the institutional framework underlying the current crisis. Organizations represent powerful interests (which could be considered their own or those of their agents) that have a bearing on the survival of the institutional framework in the domain of the organization’s operation and influence. I contend that many institutions, in fact, cannot survive today without the active support and sanction of organizations. This is particularly valid for the formal and informal institutional framework underlying the financial industry organizations. I thus argue that the “engine” of institution-organization influence identified by DiMaggio and Powell (1983) works both ways in its effects. Things have indeed changed since the times of Weber, but one important change is in the power and influence wielded by organizations, particularly business and financial industry organizations, all over the world today. Assuming that multinational organizations with budgets far exceeding those of several countries put together are necessarily passive players submissively seeking legitimacy in their interaction with institutions is an anachronistic thought. Business and financial organizations today are powerful beyond imagination, and have a role in influencing, shaping and manipulating anything that happens to be in the way of their survival and success. And what else could be more “in their way” than institutions? While institutions attempt to impose their constraints on organizations, organizations are busy twisting the iron cage inside-out over the institutions, i.e. determining through their actions which institutions survive and succeed in their domains. In today’s world, the power equation between organizations and institutions is such that one’s answer to “Who is caged?” with respect to the organizational-institutional interplay might well depend on the perspective one chooses, i.e. from which side of the iron mesh one views the world. 2.1 Reverse-legitimacy DiMaggio and Powell (1983) concede the active role of organizations when they state that organizations try to change constantly, yet the aggregate effect of such change is homogenization. I argue that this homogeneity could also serve to legitimate the institutions whose forces underlie the institutional isomorphic processes. This mutual

legitimation could give rise to a “contagion of legitimacy” amongst the organizations and institutions involved. Institutions have power over organizations to the extent that they can grant legitimacy to organizations, or can make an organization that does not conform to institutional pressures “illegitimate”. I contend that with the emergence of powerful business and financial organizations, this “legitimacy” flows both ways. Not only does the appearance of conformance to institutional pressures have a role in organizational success, but organizational success in turn confers a “reverse-legitimacy” upon certain institutions that are deemed to have had a role in the success of organizations associated with these institutions. If organizations within the organizational field are successful in the aggregate, the institutions from which the organizations have sought legitimacy (through conforming to the isomorphic pressures generated by these institutions) are sanctioned as having been responsible for giving rise to such successful organizations. In reality, the success of organizations could be dependent on several other factors internal or external to themselves, yet their association with certain institutions provides these institutions with the “halo” of success. One sees such situations when certain public policy decisions are made to replicate institutions that are deemed to have contributed to, or even given rise to, successful organizations (Jepperson and Meyer, 1991). This is most dramatically discernible in the clear attempt by less developed countries to imitate institutions from countries where powerful business and financial organizations have succeeded, and to then invite these powerful organizations to the host countries and hope for similar success of these and similar organizations. The proliferation of “free trade zones”, “special economic zones”, “commercial regions”, etc., in parts of the world that generally do not have institutions similar to the developed world is partly an attempt to provide powerful organizations with institutional structures of their liking, in which they have succeeded elsewhere. Thus, organizations can “reverse-legitimate” institutions in the same way that institutions “legitimate” organizations. The institutional environment has been thought of as consisting of institutions nesting with one another (Jepperson, 1991), and of interrelated networks of mutually supportive or antagonistic parts, giving rise to “contagions of legitimacy” (Zucker, 1977). The concept of “contagions of legitimacy” is a useful one, with my additional insight being that business and financial organizations are a core part of such contagions, due to the ability of powerful business and financial organizations today to “reverse-legitimate” institutions through their own success. Groups of institutions and organizations form “contagions of legitimacy” and the survival or failure of institutions or organizations in such contagions is intricately connected. The concept of “reverse-legitimacy”, related to the idea of “contagions of legitimacy” is much needed to allow for further theoretical development 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 current crisis. 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 successful organizations in the aggregate, which helped sanction the formal regulatory institutions (particularly the Securities and Exchange Commission, but also the Federal Reserve and its credit expansion and inflationary policies) and also informal cultural-cognitive and normative institutions (for example, the cultural acceptance of high debt and excessive home mortgages). This “reverse-legitimation” of institutions underlying the financial industry success also had international ramifications as theoretically delineated above. The institutional transformations associated with the financial industry in emerging markets (e.g. China and India) and transition countries (e.g. Eastern Europe), both in terms of the formal regulatory institutions and also in terms of the cultural-cognitive and normative institutions suggest attempts at replication of features of American and Western European “successful” institutions. For example, countries where cultural-cognitive and normative institutions had historically pushed people to save saw a cultural shift and a move towards acceptance of debt, while the regulatory institutions eased up to allow financial organizations to set up businesses similar to ones they had succeeded in elsewhere. A “contagion of legitimacy” was therefore created that primarily included the financial organizations in the USA and Western Europe along with the formal and informal institutions underlying this industry’s success in this part of the world. Over time, this contagion spread across several parts of the globe where these and similar financial organizations set up businesses and features of the underlying formal and informal institutions were replicated. In summary, I propose the following: while conforming to institutional pressures, powerful organizations, through their success, can “reverse-legitimate” the institutions that underlie these pressures, and this reverse-legitimation has a positive effect on the survival 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 current crisis, financial organizations in the USA, through their success in the aggregate, were able to reverse-legitimate formal and informal institutions in the USA, and this reverse-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 crisis While organizational success in the aggregate reverse-legitimates institutions, this is no guarantee of organizational conformance to all pressures from the underlying institutional framework. Though organizations derive legitimacy through the “contagion of legitimacy”, they can further manipulate the legitimacy-granting process through strategies that help avoid institutional pressures not in line with parts of their structure (Kraatz and Zajac, 1996; Suchman, 1995). Under certain conditions, the “contagion of legitimacy” could then head for a crisis. These theoretical arguments are delineated here and relevant to understanding how the current crisis developed and where such crises could lead. Organizations use a strategy of decoupling when faced with institutional pressures not in line with their existing structures (Meyer and Rowan, 1977). This involves symbolic conformance to the institutional pressures through the organization’s

institutional layer, and substantive non-conformance in technical aspects (Ashforth and Gibbs, 1990). Oliver describes similar strategic responses as “conceal” and “buffer” mechanisms, i.e. when an organization disguises non-conformity behind a fac¸ade of acquiescence or loosens institutional attachments, respectively (Oliver, 1991; Oliver, 1996). I extend these ideas to see the major implications such organizational strategies eventually have on the fortunes of the institutions involved. I argue that a strategy of decoupling or concealment by powerful and successful organizations, prolonged over a period of time, has a negative effect on the survival of such institutions. Initially, while organizations attempt to comply in substantive terms, a few might discover ways to conceal compliance or comply only in symbolic terms while leaving their substantive aspects free from institutional pressures. The ability to carry out such a decoupling or concealment confers an advantage to these few organizations over others, since they are able to derive legitimacy from the institutions in question, and at the same time keep their technical or substantive aspects free to perform as necessary for efficiency reasons. Once such a strategy is discovered and implemented as a successful way of dealing with “undesirable” pressures from institutions, other organizations in the organizational field then mimic this strategy, particularly if it is followed by some of the more powerful and successful organizations. The situation is made worse by the ability of powerful organizations to manipulate (Oliver, 1991) the concerned institutions as well. Manipulation could be undertaken so that the organization does not have to conceal altogether, or, often more easily and conveniently, it could be undertaken to make such concealment and decoupling strategies easier to execute. The latter strategy relates to weakening the ability of institutions to detect concealment and decoupling (non-conformity of organizations in substantive terms), and is important for our analysis. As more organizations discover and implement decoupling and concealment strategies, and as implementation of such strategies becomes easier due to manipulation of the institutions by the more powerful organizations, the organizational field heads towards a legitimacy crisis. While the pursuance of symbolic conformance creates a heightened perception of organizational legitimacy to those 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 of legitimacy (for organizations comprising the organizational field) to those outside the organizational field, while increasing “illegitimate” structures within the field. The homogenization of the field is thus achieved, in part, through organizational strategies that make “illegitimate” structures widely prevalent. The scenario is akin to that of a bubble, or a house of cards. At some stage, if the “illegitimacy” of a few organizations, particularly the more successful ones, within the organizational field becomes well-known outside the field, a domino effect occurs whereby the legitimacy of all organizations that have until now been considered as complying in all their aspects becomes suspect. Most importantly for our purpose, this has a dramatic effect on the institutions involved as well, since their legitimacy-granting powers become suspect: they are seen as having bestowed “legitimacy” to organizations with

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“illegitimate” structures within the organizational field. The case of investment banks in the USA is particularly relevant here. Investment banks needed to avoid institutional pressures that were in conflict with substantive aspects of the banks’ operations related to subprime mortgage risks, yet the nature of their businesses is such that they need to be seen as legitimate. To overcome 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 or concealment, along with manipulation where possible, helped banks carry on these substantive operations while maintaining the symbolic legitimacy, for a while. Such situations are, however, too good to last. Once the discovery of “illegitimate” structures within powerful and successful investment banks became public knowledge outside their field, the legitimacy of all investment banks along the relevant dimensions became suspect. We therefore see how the domino effect spread through the largest Wall Street investment banks and other financial industry organizations, shaking up the entire financial industry and organizations beyond that were deeply connected to this industry. Three of Wall Street’s five large banks ceased to be legitimate independent businesses within six months. Bear Sterns was bought by JPMorgan, Lehman Brothers filed for bankruptcy, and Merrill Lynch faced bankruptcy and was bought by Bank of America. A key aspect here is the change in organizational form to escape the legitimacy crisis due to the deinstitutionalization of their erstwhile organizational forms (Davis et al., 1994) that were part of the earlier “contagion of legitimacy”. For example, Goldman Sachs and Morgan Stanley changed organizational form to cease being specialized investment banks and became deposit holding banks. Bear Sterns and Merrill Lynch, earlier highly legitimate specialized investment banks, in effect changed organizational form through being acquired by universal banks JPMorgan and Bank of America, respectively. As the crisis spread across the erstwhile “contagion of legitimacy”, other organizations in the field faced a sudden loss of legitimacy: mortgage giants Fannie Mae and Freddie Mac had to be saved through nationalization and insurance behemoth American Insurance Group asked to be saved by a government loan. Ultimately, formal institutions also bear the brunt of this collapse of the “contagion of legitimacy”, as they could lose their legitimacy granting powers and be themselves considered illegitimate. In the present scenario, skepticism is currently on the rise regarding the legitimacy granting powers of the Federal Reserve through its credit expansion and inflationary policies, the Treasury, the SEC, and governmental efforts based on these institutions to stabilize and provide legitimacy to the financial industry organizations. Similarly, informal institutions, such as the cultural-cognitive and normative acceptance of aggressive high-risk investments, high debt, excessive mortgages, disregard for savings, etc., are in question, and taken for granted assumptions about these are challenged. In other words, these informal institutions lose their legitimacy granting powers that bestowed legitimacy on financial industry organizations. This questioning and challenge of the formal and informal institutions is what manifests itself as widespread behavior that results in the flight of funds from equities, banks and other financial organizations, and even from money markets and

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. Discussion In this paper, I support the use of the emerging literature in new institutional theory on the interplay of organizations and institutions to understand the current financial crisis. I provide fresh concepts and theoretical arguments on how organizations, particularly powerful and successful ones, could have an impact on the fortunes of institutions in their operating domains. My view is that a two-way influence in the institution-organization interplay has to be expected, particularly considering the existence of highly powerful and successful organizations today, that actively pursue their own interests (or those of their controlling agents). In other words, I argue for looking at the iron cage of DiMaggio and Powell (1983), inside-out, to use the same imagery, in order to understand the current global financial crisis. The ideas presented here are useful to explain the present financial crisis by focusing on the major players in the financial industry and major formal and informal institutions relevant to these players. However, the organizations and institutions considered here could also be extended to include a broader set of players in the global arena. Further, the interplay between organizations and institutions could be explored further at a finer level of granularity. For example, the recent International Monetary Fund involvement in the present crisis in countries such as Ukraine, and the European Central Bank providing credit to Hungary, could constitute cases for more detailed analysis using the concepts discussed here. In particular, cross-border organizational-institutional interplay, such as that arising from the banking industry disputes between Iceland and the UK, could comprise interesting topics of research using new institutional theory. New theoretical insights could be developed through grounding future research in such contexts and extending the conceptual ideas presented in this paper. The analysis in this paper suggests that those working for resolutions should attempt to understand the complex interplay of financial industry organizations and broader institutions, particularly with an emphasis on how this interplay provides perceptions of legitimacy to both parties. Simplistic notions of institutions pressurizing organizations in the organizational field to conform in order to seek legitimacy do not always apply, and could prove futile yet again in the future. The reality is more complex and notions of “reverse-legitimacy” and “contagions of legitimacy” are more useful. Fundamental questions about the nature of these institutions and their legitimacy-granting powers need to be raised, along with a focus on the powers that business and financial organizations, individually and collectively wield to “reverse-legitimate” these institutions. Further, wide use of decoupling strategies by business and financial organizations, such as the case of investment banks and high-risk mortgage-backed securities, could eventually trigger institutional crises that call into question legitimacy-granting powers of existing formal and informal institutions. The current crisis thus calls for examination as an institutional crisis resulting from the interplay of the involved financial industry organizations and broader formal and informal institutions. This paper provided theoretical insights to enable our

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understanding of this interplay and potentially shape future policy relevant to this crisis and to similar potential crises in the future. Through grounding theoretical arguments in the context of the present crisis, this paper also introduced new concepts that would further theoretical and empirical work within emerging streams of new institutional 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 American community colleges”, in Powell, W. and DiMaggio, P. (Eds), The New Institutionalism in Organizational 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 of an organizational form”, American Sociological Review, Vol. 59, pp. 547-70. DiMaggio, P. (1991), “Constructing an organizational field as a professional project: US art museums, 1920-1940”, in Powell, W. and DiMaggio, P. (Eds), The New Institutionalism in Organizational Analysis, The University of Chicago Press, Chicago, IL, pp. 267-92. DiMaggio, P. and Powell, W. (1983), “The iron cage revisited: institutional isomorphism and collective 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 institutional account of the causes of diversification in the largest firms, 1919-1979”, in Powell, W. and DiMaggio, P. (Eds), The New Institutionalism in Organizational Analysis, The University of Chicago Press, Chicago, IL, pp. 311-36. Galaskiewicz, J. (1991), “Making corporate actors accountable: institution-building in Minneapolis-St Paul”, in Powell, W. and DiMaggio, P. (Eds), The New Institutionalism in Organizational Analysis, The University of Chicago Press, Chicago, IL, pp. 293-310. Garud, R., Jain, S. and Kumaraswamy, A. (2002), “Institutional entrepreneurship in the sponsorship 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 e´lite firms in mature fields: 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 formal organizations”, in Powell, W. and DiMaggio, P. (Eds), The New Institutionalism in Organizational 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 causes and consequences of illegitimate organizational change”, American Sociological Review, Vol. 61, pp. 812-36.

Meyer, J.W. and Rowan, B. (1977), “Institutionalized organizations: formal structure as myth and ceremony”, American Journal of Sociology, Vol. 83, pp. 340-63. Oliver, C. (1991), “Strategic responses to institutional processes”, Academy of Management Review, Vol. 16 No. 1, pp. 145-79. Oliver, C. (1996), “The institutional embeddedness of economic activity”, Advances in Strategic Management, 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”, Academy of Management Review, Vol. 20 No. 3, pp. 571-610. Zucker, L.G. (1977), “The role of institutionalization in cultural persistence”, American Sociological Review, Vol. 42, pp. 726-43. About the author Suhaib Riaz (PhD, Richard Ivey School of Business, University of Western Ontario, Canada) is an Assistant Professor of Strategy at the University of Ontario Institute of Technology at Oshawa, Canada. His research interests include institutional embeddedness of key employees and organizational capabilities, and organizational action and institutional change. Suhaib Riaz can be contacted at: [email protected]

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Saint Mary’s College of California, Moraga, California, USA Abstract Purpose – The purpose of this paper is to expand understanding of the current global financial crisis in light of other large-scale financial crises. Design/methodology/approach – The phenomenon of large-scale financial crisis has not been modeled well by neo-classical general equilibrium approaches; the paper explores whether evolutionary and complex systems approaches might be more useful. Previous empirical work and current data are coalesced to identify fundamental drivers of the boom and bust phases of the current crisis. 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-) are associated with structural changes in institutions, technologies, monetary processes, i.e. changing “meso structures”. Increasingly, purely financial constructs and processes are dominant infrastructures within the global economy. Research limitations/implications – Rigorous analytical predictions of financial crisis variables are at present not possible using evolutionary and complex systems approaches; however, such systems can be fruitfully studied through simulation methods and certain types of econometric modeling. Practical implications – Common patterns in large-scale financial crises might be better anticipated and guarded against. Better money-liquidity supply decisions on the part of official institutions might help prevent economy-wide money-liquidity crises from turning into systemic solvency crises. Originality/value – Scholars, policymakers, and practitioners might appreciate the more comprehensive evolutionary and complex systems framework and see that it suggests a new political economy of financial crisis. Despite a huge scholarly literature (organized recently as firstsecond- 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 Paper type Viewpoint

critical perspectives on international business Vol. 5 No. 1/2, 2009 pp. 36-55 q Emerald Group Publishing Limited 1742-2043 DOI 10.1108/17422040910938677

1. Introduction The current global financial crisis has many patterns in common with other recent large-scale financial crises, including in developed countries (e.g. Finland and Sweden in 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 historical literature on boom-bust processes, and despite a flurry of topical essays in recent months, some of these more important patterns are only now being identified. Section 2 summarizes recent taxonomies with particular attention to the current situation. In order to describe the current crisis, first-, second-, and third-generation financial crisis models, which are found in the economics literature, are all helpful, but remain incomplete, especially in explaining “non-equilibrium” movements in exchange rates, interest rates, international investment flows, stock market and real estate

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

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37 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 somewhat more by subjective, even transcendental (of observable gross domestic product – GDP – or “real” processes) psychological and social constructs than is commonly understood. Since the 1980s, structural changes in evolving financial markets, especially advances in information-processing technology and government deregulation, have allowed a greater separation of financial market processes from GDP processes. Specifically, as per the econometric research of one of the authors, the demand for money-liquidity for financial market participation has become – especially during episodes of chaotic structural change – an important source of money demand which absorbs money-liquidity away from observable GDP uses. As a related process, monetary wealth can thus be created, transferred, and destroyed across time and space more powerfully and independently of observed GDP processes than is commonly understood. Second, as elaborated in Section 5, expanding our understanding of the current crisis can be assisted by evolutionary and complex systems approaches, especially ones that privilege the role of interactive knowledge and belief systems. The relative rise and fall of interactive institutional and technological systems, or “meso” structures in the language of evolutionary economics, are seen to play a key role in driving the current boom-bust pattern. Transitions and imbalance between meso structures can account for long-run discontinuities or instabilities beyond what can be explained by normal business cycle theory. These conclusions are then summarized in Section 6 as they might direct us toward a new political economy of financial crisis. 2. Definitions and common patterns A “financial crisis” is generally defined to be “a wider range of disturbances, such as sharp declines in asset prices, failures of large financial intermediaries, or disruption in foreign exchange markets” (De Bonis et al., 1999). There is a “crisis”, generally speaking, because the real economy is seriously and adversely affected, including negative impacts on employment, production, purchasing power, as well as the possibility that large numbers of households and firms or governments are fundamentally unable to meet their obligations, i.e. “insolvency”. When an organization is fundamentally solvent but temporarily unable to meet its financial obligations, then the notion of “illiquidity” is often used, but in practice insolvency and illiquidity are difficult to distinguish. For example, a common pattern is that “vicious circles” start from a money-liquidity crisis at a few banks, which then extends to an international crisis of investor confidence in the financial sector, which extends to a balance of payments problem for the country and currency devaluation, which extends to, 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) and others, emphasize the importance of a country’s foreign exchange reserves, i.e. if government budget deficits are excessive, then ultimately a government loses the ability to maintain these reserves, and a speculative attack on its currency exchange rate is inevitable. Second-generation models, as summarized by Rangvid (2001), arose during the 1990s when this cause-effect linkage no longer explained various currency crises. In particular, there is now a weaker relationship between economic fundamentals such as public sector deficits and the timing and severity of speculative currency attacks and related instabilities. The timing of government decisions to abandon a currency regime in favor of other political-economic goals has also proved difficult to predict. Second-generation models thus tell stories of “multiple equilibrium” values that key variables might assume, unpredictable or irrational behavior by private investors and governments, and there has been an effort to discover new “sunspot variables” that will better explain sudden changes in markets. Third-generation models, as per Krugman (1999) and Allen et al. (2002), introduce additional variables and feedback processes, especially the role of companies’, entrepreneurs’, and governments’ balance sheets, and the impact of international financial flows and exchange rates on those balance sheets. During and after the 1997 Asian financial crises, the financial condition of firms weakened more than was anticipated by second-generation models, which drew attention to these processes. Furthermore, until new entrepreneurs come forward, or until balance sheets return to normal, 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 initially benefits from expanded supplies of base money, new “quasi-moneys” which are created from base moneys, and credit supplies – a financial liberalization and deregulation phase. Typically the financial sector expands as it captures profit from new efficiencies and opportunities allowed by globalization. The country or region, for a time, may be favored by international investors; thus the banking system, including government, is well-capitalized and able to expand money-liquidity. Assets increase in monetary value and interest rates are low, and this wealth effect encourages consumption, borrowing, business investment, and government spending. Productive resources 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 sectors of an economy, such as the value of stocks, real estate, currency reserves, etc., and/or the current production of merchandise and services (GDP). Then, typically, the supply of base money (m) times its rate of circulation or velocity for GDP purposes (v) contracts, and therefore so does the equivalent nominal GDP. The decline in nominal GDP is usually split between its two components: (1) real GDP, which is the volume of current production measured in constant prices (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 a recession, and when p declines we call it deflation. After this process starts, monetary

policymakers may react by rapidly expanding (m), but this action may be too little too late – 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 this pessimistic case, which is typical in less-developed countries with weak financial systems, the desperate increase in m may reverse the slide in p and even lead to hyper-inflation (destabilizing, rapid increases in p), but q would continue to fall. Also, a weak financial system may be unable to maintain the circulation rate of secure currencies for productive activities, especially if people are hoarding money, and thus v would decline. The initial contraction in “effective money” (m £ v) in a crisis may be caused by monetary authorities or national and international investors draining money (m) from the country or region, or there may be a decline in v for reasons having to do with the inability of the financial system to direct money toward productive activities. A contraction in effective money or withdrawal of international investment may undermine equity markets, debt markets, bank capital, or government reserves, and monetary wealth is then revalued downwards. General economic or political uncertainty worsens the situation – the resulting austerity-mentality causes a contraction of spending and credit, and an increased “risk premium” attached to business activity scares away investment and bank lending. Interest rates rise, the demand 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 more secure base money, Treasury securities, and other more secure assets. No reserve-currency banking system is able to cover all of its monetary float with secure 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 sector may be unable to honor its deposits, bad loan problems surface and a “lender of last resort” 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 global financial crisis? The authors agree with many other commentators, such as Reinhart and Rogoff (2007), that the current crisis fits many historical patterns, as explained next with emphasis on the US situation. In particular, Reinhart and Rogoff (2007) find that: . . . the run-up in US housing and equity prices that Kaminsky and Reinhart (1999) find to be the best leading indicators of crisis in countries experiencing large capital inflows closely tracks 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 crisis was driven in the early 1980s by widespread deregulation of financial markets in the developed world especially the Reagan administration reforms in the USA and the Thatcher administration reforms in the UK. These policies were guided by ideologies and belief systems aimed at restoring a more capitalist tradition, and they eventually prevailed across the global system. French President Mitterrand’s attempt to advance a more socialist set of values and policies floundered by late 1982 and financial market deregulation and international integration spread not only in Europe and North America, but also Asia, Latin America, Africa, and Eastern Europe. Newly unregulated financial 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 international arbitrage. The commoditization and securitization of financial products by the private sector, including through virtually unregulated no-reserve-requirement “offshore banking facilities” led to dramatic increases in international money liquidity and credit, and by the end of the 1980s, global financial markets were generating a net international flow of funds of more than $3 trillion each month, i.e. the flow of funds between countries that reconciles end of the month balance of payments accounts. Of that $3 trillion, $2 trillion was so-called stateless money, which was virtually beyond the control of any government or official institution, but available for use by all countries (Barron’s Magazine, 1987, p. 45). This 1980-2006 boom phase of the current crisis was driven by fundamental changes in the basic social and technical rules of the game, or “meso” structure of the global 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, more free-market, technologically innovative, decentralized, and chaotically-individualistic meso structures as financial globalism prevailed. As one of the authors has elaborated elsewhere (Allen, 1999), these structural changes associated with financial globalization supported an increasing net financial inflow from the rest of the world into the USA from near-balance in 1980 to approximately $800 billion per year or 6 percent of GDP as a net financial inflow in 2006 – the peak of the long boom – which supported classic-pattern excesses in low-interest rate debt financing and spending, monetary wealth creation processes, consumerism and financial asset inflation, and now-famous lax standards in mortgage financing and securitization vehicles such as “collateralized debt obligations” and “structured investment vehicles” that passed the rights to the mortgage payments and related credit/default risk to third-party investors. The US household personal savings rate dropped from 8 percent of disposable income to 0 percent over this 1980-2006 period, while the “net wealth of the US” (net value of business assets, real estate, consumer durables, and US government property) increased from approximately $7 trillion to $50 trillion in nominal terms. The end of this long boom from the early 1980s to 2006, and the beginning of the crisis or bust phase, began with the bursting of the US housing bubble and a sharp rise in home foreclosures in the USA in late 2006, which spread to become a more broad-based global financial crisis within a year. The mortgage lenders that retained the risk of payment default, such as Countrywide Financial, were the first financial institutions to be affected as borrowers defaulted. Major banks and other financial institutions reported losses of approximately $100 billion by the end of 2007. By October 2007, 16 percent of subprime loans in the USA with variable interest rate features were 90 days delinquent or in foreclosure proceedings, roughly triple the rate of 2005, and by January of 2008, this number increased to 21 percent. Losses in the money-credit pyramid then began to spread across the system including through the collapse in June 2007 of two hedge funds owned by Bear Stearns that 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 a Bear Stearns bankruptcy by assuming $30 billion in its liabilities and engineering the sale of Bear Stearns to JPMorgan Chase. In August 2008 the US Treasury (and

therefore the US taxpayer) joined the LOLR phase by taking over and guaranteeing the funding of Fannie Mae and Freddie Mac, the quasi-government housing market entities. In September 2008 American International Group, because of its exposure to credit default swaps, was bailed out by the Federal Reserve in an $85 billion deal, and then later that month the US taxpayer-sponsored $700 billion bailout bill was passed after Congress amended the plan to add more oversight, limits on executive pay, and the option for the government to gain equity in the companies that it bails out. As in Finland and Sweden’s crises in 1991, Europe and the USA quickly moved to acquire equity stakes in, and partly nationalize, the banks. As this essay is written in late 2008, the world thus moves quickly to regain coordinated state “social market capitalism” control of the financial system, i.e. back toward the pre-1980 “meso” rule structures that were more hierarchically organized and communitarian-disciplined (by treasuries and central banks and other official institutions) in place of the more free-market innovative, decentralized, and individualistic rule structures that dominated between 1980 and 2008. In testimony before the US Congress on 23 October 2008, former US Federal Reserve Chairman Alan Greenspan famously said that “I made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such that they were best capable of protecting their own shareholders”. 3. The role of psychological and social factors Second- and now third-generation models of financial crisis, while simulating many common patterns, do not yet explain sudden movements in exchange rates, interest rates, international investment flows, stock market and real estate values, and other key variables to levels beyond normal fluctuations. Thus, there is a revival of interest in what Keynes, in The General Theory, called “animal spirits” such as “spontaneous optimism” among entrepreneurs and others (Marchionatti, 1999). Essentially, Keynes argued that people may have a limited cognitive and informational basis for fully rational decision-making, and therefore, they may rely on less rational social conventions, vague beliefs, and other psychological factors. One implication is that: . . . the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation (Keynes, 1936, p. 154).

As authoritatively summarized by Kindleberger (1989) in Manias, Panics, and Crashes: A History of Financial Crises, over the long history of market capitalism, the start of an unsustainable financial boom or “mania” is always linked to a sudden increase 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 economic instabilities and crises], and not merely because it ignores the money supply. Monetarism is incomplete, too. A synthesis of Keynesianism and monetarism, such as the Hansen-Hicks IS-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 the most 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 political economy, of subjective expectations, leveraged investment as supported by new electronic and derivative money and credit forms, unregulated no-reserve-requirement offshore financial markets, etc., some current research is consistent with the innovative notion that monetary-wealth, or what Marx called “unproductive finance capital” (as opposed 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 new global financial markets may even be an “infrastructure of the infrastructure”. Cerny’s initial position, elaborated in debates that began in the early 1990s, was that “a country without efficient and profitable financial markets and institutions will suffer multiple disadvantages in a more open world [. . .] [and will] attempt to free-ride on financial globalization through increasing market liberalization” (Cerny, 1993, p. 338). Helleiner (1995) restrained this position – of a determinist, autonomous, technology-driven financial 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, the editors 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, of course, has many aspects [. . .] The first of these is the emergence of a truly global financial market [. . .] and the resulting increase in the power of finance over production (Review of International Political Economy, 1994, p. 3).

Reversing the causality of Karl Marx’s (and many others’) philosophical materialism, it may increasingly be true that autonomous, invisible financial processes can drive changes in the physical relations of production, as well as vice versa. As part of this process, central banks and other financial market participants can (usually haphazardly) increase or reduce wealth independently of any initial changes in the production of GDP or other “real” economic prospects. The Chairman of the US Federal Reserve, Alan Greenspan, began allowing for this possibility in the late 1990s: Today’s central banks have the capability of creating or destroying unlimited supplies of money and credit [. . .]. It is probably fair to say that the very efficiency of global financial markets, engendered by the rapid proliferation of financial products, also has the capability of transmitting mistakes at a far faster pace throughout the financial system in ways that were unknown 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 the ability to generate losses at a previously inconceivable rate (Greenspan, 1998).

The authors would emphasize from Greenspan’s quote that “the capability of creating or destroying unlimited supplies of money and credit” is equivalent to “the capability of creating or destroying monetary wealth”. Money and credit are “stores of value”, as determined by social consensus within nations and between nations. Transcendental notions of value applied to monetary assets need not reflect, or even be compatible with, the observed empirical world. For example, the purely transcendental “law of compound interest” is a social agreement, which may not correlate with the way that the physical economy grows. Growth in the physical economy is subject to thermodynamics, biological growth processes and carrying

capacity, endowments of resources, sunlight and rain, etc. Perhaps debtors as a group, who are required to pay exponentially increasing interest under this transcendental law, can generate goods and services and therefore economic revenues only in arithmetically increasing increments over time. Therefore, perhaps some debtors have to fail, and yield their economic resources to the others, so that the others can meet their obligations. Invisible belief systems, including those of money-gamblers and optimistic market capitalists, have supported a money economy based on exponential interest payments, and an easing of lending restrictions. The acceptance and growth of offshore finance in the 1980s and 1990s, without reserve requirements or other significant regulations, is an example of how belief systems – in this case market capitalist ideology — drive institutional change. Offshore market institutions, such as the Bangkok International Banking Facility, encouraged unsustainable over-lending, excessive unprofitable construction 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 their supporting institutions can thus drive empirical changes in human populations and their physical environments. Much of the economic wealth that was initially created through deposit-lending, as it exercised itself in production power, consumption power, and power to change institutions, was destroyed in the recent Asian crisis, but it nevertheless did exist as a broad social agreement. Whether or not financial crises arising from over-indebtedness and deflation – as per Irving Fisher’s classic work (Fisher, 1933) – should be systemically expected in modern capitalism has been debated. Mainstream economic thinking has until recently been generally confident that “hard-to-qualify” lending-restrictions, wherein all parties are conscious of systemic risk, can avoid over-lending and debt-failure. In contrast, Marxists (see Clarke, 1994) and others across various disciplines, such as Frederick Soddy (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 centuries and 68 countries shows “a perennial problem of serial default [. . .] in this respect the 2007-08 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-crises between, on the one hand, the belief system which includes mathematical compound interest, and on the other hand, the ability to generate money from tangible “real world” processes. Some borrowers and lenders are well informed but reckless risk-takers who know that periodic failures are required in “casino capitalism” (John Maynard Keynes’s phrase), whereas other borrowers and lenders underestimate systemic risk and allow over-lending based upon a mistaken ideology regarding the stability of the system. Thus, on both accounts, the literature generally concludes that debt crises are likely to remain with us. 4. New thinking 4.1 What do the authors propose to contribute to this literature? First, in the authors’ view, key financial variables can be driven somewhat more by subjective, even transcendental (of observable GDP or “real sector” processes) psychological and social constructs than is commonly understood. Consequently, there has been an even greater separation of financial market processes from GDP processes than is commonly understood. And, monetary wealth has thus been created,

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Figure 1. Structural declines in the income (GDP) velocity of money in the 1980s: identifying the start of the current financial boom (Source: IMF)

transferred, and destroyed across time and space more powerfully and more independently of observed GDP processes. Second, a better understanding of the current crisis can be assisted by evolutionary and complex systems approaches (as elaborated in Section 5), especially ones that privilege the role of interactive knowledge and belief systems and the psychological and social factors discussed above. The econometric work of one of the authors (Allen, 1989, 1999) supports this “new thinking” – essentially by showing that, under certain conditions, financial markets can “absorb” a portion of the money supply, such that the absorbed money is not contemporaneously available to support and induce the “real economy”. While economic literature has examined various demands for money for financial market participation, the author’s contribution to that literature was the first to show that the absorbed money was not simultaneously available even to induce or incentivize GDP activity. 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 broad money 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 reengage GDP production or consumption, or it might be destroyed in a financial crisis before its title-holders can use it. Therefore, money is not a neutral driver of the real economy over time. Furthermore, this absorption process can occur to facilitate the boom phase of a financial crisis cycle, and it can also facilitate the bust phase – by driving asset values beyond normal or sustainable levels. For example, Figure 1 shows a structural decline in the long-term trend GDP velocity of money (v) in the USA, the UK, and Canada in the early 1980s that corresponded with the beginning of the boom phase of this current financial crisis. In each of these countries, corresponding with the particular timing of the break in v, governments dramatically abandoned financial market protectionism. Policymakers removed ceilings on interest rates, reduced taxes and brokerage commissions on financial transactions, gave foreign financial firms greater access to the home financial markets, allowed increased privatization and securitization of assets, and took other steps that allowed money to move more freely and profitably between international and national markets. As can be seen in Figures 2 and 3 for the USA and the UK, in these key “phase shift” years, there was a corresponding dramatic expansion in the transactions volumes of money-absorbing financial transactions (measured as the combined value of stock, bond, and government securities transactions) – shown as an inverse relationship between v and financial transactions volumes. In the USA, the major structural break in v along with other monetary-transmission relationships

occurred in 1982 as participants responded to newly profitable forms of liberalized financial 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 as participants anticipated the UK’s “big bang” of October 1986, which ended fixed commissions for brokers and separation of powers between brokers, and allowed a rush of foreign financial firms into the marketing of British stocks and government bonds and other securities. In addition to the direct absorption of money away from GDP activity to accommodate transactions demands for exploding volumes of financial activity, a related form of absorption occurred in the UK case due to uncertainty or information failure experienced by holders of money. That is, during a dramatic upheaval or structural change as per Big Bang, financial portfolios must be reallocated dramatically as the new opportunities are figured out and reacted to. For a time, there is not sufficient information for investors to pursue rational strategies, and the price of money-liquidity rises sharply. An increase in money demand occurs to reduce the risk of loss and in order to regain an optimal portfolio quickly once the information environment improves. In the authors’ view, this “options demand” for money can divert money-liquidity away from GDP and other markets during chaotic times (once again such that GDP activity is neither accommodated or incentivized by this portion of the money supply –

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Figure 2. Expanding volumes of money-absorbing financial transactions in the USA ($trillion/year) and the US income velocity of money (M1)

Figure 3. Expanding volumes of money-absorbing financial transactions 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 economics profession. However, many securities market professionals swear by it. For example, Joseph Grundfest, former Commissioner of the US Securities and Exchange Commission, explained the 1987 world stock market crash as follows: Simply put, I suggest that a large component of recent market volatility is the rational result of an “information failure” in the market for liquidity rather than the consequence of rapid and irrational changes in the market’s assessment of the value of securities [. . .] The lack of information about either fundamental business prospects or about the magnitude and composition of an atypically large demand for immediate trading can be sufficient to induce substantial market volatility [. . .] [A] sharp increase in the price of liquidity is reflected in a simultaneous widening of spreads and in a general price decline in the equities and futures market alike [. . .] Once sufficient information comes to the market describing expected short-term trading flows, and once the returns to providing liquidity become high enough, the peak-load nature of the demand subsides, the risk involved in trading is reduced, the price of liquidity 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 with similar declines in real estate and other asset prices after 1989, shows how this money absorption can occur in the bust phase of a financial crisis. Namely, absorption of base money by financial markets and therefore a decline in its rate of circulation for GDP purposes (v), in times of financial distress, can also be measured by a weakness in the growth of broad money. Expanded supplies of high-powered money may not be able to serve as a base for expanded supplies of broad money if the high-powered money supplies are instead consumed by financial institutions to resolve bankruptcies, increase reserves, and meet other capital requirements. In this case, a decline in broad money would correspond to a decline in the velocity of high-powered money as it is absorbed by distressed financial markets rather than being used to support growth in GDP. Japan’s narrow (M1) velocity began dropping significantly in the early 1990s – by approximately 30 percent from a value of 3.5 ( ¼ nominal GDP divided by M1) in 1990 to 2.5 in 1995. Just as dramatically, Figure 4 shows the big decline in the growth of Japan’s broad money supply (M2 þ CDs) in the 1990s which correlated with declines in

Figure 4. Japan’s financial crisis. The dramatic decline in Japan’s broad money supply growth rate (M2 þ CDs) in the 1990s was correlated with declines in the stock market, real estate values, and real GDP

the stock market, real estate values, and real GDP (in July 1998 a GDP recession began but was mostly avoided). Maintaining the growth of the narrow money supply (M1) did not prevent deflation and recessionary conditions, because more of the M1 was absorbed by distressed financial institutions. Elaborating this situation further, research in 1998 indicated that:

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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 is low and default risks are high as in Japan today, low interest rates reflect expectations of both low (or negative) inflation and rates of return. In such a situation, the appropriate focus of monetary policy is on money and not interest rates [broad money supplies should be expanded despite low interest rates] (Federal Reserve Bank of St Louis, 1998, p. 1).

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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, real estate 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 of high-powered money are not yet serving as a base for expanded supplies of broad money as the high-powered money supplies are instead consumed by financial institutions to resolve bankruptcies, increase reserves, and meet other capital goals in an environment of uncertainty and information failure. There is a decline in the income velocity of narrow money supplies and recession and the risk of deflation in the real sector are imminent. Although the US Federal Reserve took the controversial decision to stop reporting broad US money supply M3 data (supplies of cash and a wide range of bank instruments) in 2005 on the grounds that the modern financial system made this data unmanageable and not useful, estimates compiled by Lombard Street Research show a decline 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 CD decline in 1991-1992 as shown in Figure 4. A continuing decline in estimated US M3 in July 2008 by $50 billion was the biggest one-month fall of US. M3 since modern records began in 1959. The US M1 growth rate, which had fluctuated around 0 percent during 2006 and 2007 and the first half of 2008, was dramatically increased by the Federal Reserve (too little too late in the view of the authors) to approximately 5 percent in September 2008 (and thus it has not served as a base for expanded supplies of broad money as these supplies are instead consumed by financial institutions in distress). As this article is written, with nominal GDP declining from trend, the recent 5 percent increase in the growth rate of US M1 translates into a greater than 5 percent structural decline in the US income velocity of money (M1). What will prove interesting to estimate, when a few more quarters of GDP data are available, is whether the econometric equations (Allen, 1989, 1999) that measured the share of narrow money supplies contemporaneously absorbed for financial purposes in the boom phase of the 1980s is similar to the share of narrow money supplies absorbed for financial purposes in this bust phase. Also to be encouraged is research on whether typical boom and bust phase money absorption magnitudes across various large-scale country crises have been similar – thus supporting better money-liquidity supply decisions on the part of central banks and official institutions that might help prevent liquidity crises from turning into solvency crises.

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5. Evolutionary and complex systems approaches toward understanding the current crisis 5.1 Mainstream economic theory and financial crises The neoclassical general equilibrium model has long provided the theoretical rationale underlying mainstream economic efforts to understand macroeconomic fluctuations. This model conceives of an economy as a set of fully connected interlocking markets which can be analyzed like a force field in physics. To make the model work it is virtually imperative to assume that the market participants are homogeneous or nearly so. Prices in this model are not negotiated, they are set by a central authority (the famous Walrasian auctioneer) who assesses prevailing excess demands and imposes a set of prices that will clear all markets simultaneously. The model presumes strong tendencies towards equilibrium: it would be in equilibrium most of the time unless some exogenous force was to disturb it, in which case it would normally settle back quickly. But nominal and institutional rigidities are assumed to prevent such shocks from being perfectly damped, which generates business fluctuations. Markets in a model like this satisfy the efficient markets hypothesis and, (because of the strong equilibrium tendencies), have price changes that are Gaussian (normally) distributed. An important feature of a Gaussian distribution is that very large positive and very large negative deviations from the mean (more than three standard deviations, say) are virtually impossible. Yet price changes of these magnitudes routinely occur during financial crises. This suggests that whatever is occurring during these episodes is not following the processes embodied in the general equilibrium 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 get repaid on schedule. This condition is routinely violated in a financial crisis. Leijonhufvud (2004) notes that, despite the obvious importance of understanding better such breakdowns in the equilibrating processes, which can threaten the social order, modern macroeconomics sheds little light on their nature. LeRoy (2004), in his survey of traditional economic analyses of price bubbles, comes to a similar conclusion. 5.2 Complexity theory Given the inability of standard general equilibrium theory to explain the occurrence of financial bubbles and crises, researchers have explored other avenues. One promising approach is to look at the economic system through the lens of complexity theory. A complex system differs in important ways from the general equilibrium system of neoclassical economics. If an economy is a complex system, all behavior emanates from the bottom, from the actions of individual agents: there is no global controller or auctioneer to set parameters or behavior. Because agent behaviors interact in nonlinear ways, the macro result which emerges can have a life of its own which is not obviously deducible from the properties of the agents: the whole is not only greater than the sum of the parts, it is different as well. Positive feedback loops often exist, which amplify the effects of small changes into large cascades with significant influence. Complex systems are path-dependent, meaning that their present state is determined by what happened to them in the past (history matters). They exhibit perpetual novelty: new behaviors and structures constantly stimulate more of the same. Dynamics dominates statics; the system evolves and adapts rather than just “running” as general equilibrium models tend to do. As a consequence, a complex system is rarely in

equilibrium. It may have long periods of stability, but stability is not the same as equilibrium: it can degenerate into chaotic behavior at short notice without exogenous disturbance. This often signals what is known as a phase shift, whereby the system changes from one way of functioning to a distinctly different way. Financial crises can often be thought of as phase shifts. Because a complex system does not have strong tendencies to equilibrium, it does not usually generate variables with Gaussian distributions. Instead, it tends to produce power law distributions, which have fatter tails than the Gaussian and thus explain the frequent occurrence of extreme positive and negative values. Benoit Mandelbrot (Mandelbrot and Hudson, 2004) has been a student of financial system prices for many decades and has produced persuasive evidence that they follow power law distributions. His work, long ignored and even suppressed by efficient market theorists, is now widely recognized as correct and has been brought to the attention of the general public by Nassim Taleb (2007). 5.3 Complex adaptive systems The mathematics of complex systems has been studied for some time now and is reasonably well understood. Although phase shifts and cascades are suggestive of financial crises and power laws are consistent with frequent large price changes, complex systems were originally developed to explain inanimate phenomena such as chemical reactions. The agents in that type of complex system have no volition of their own: they passively respond to whatever natural forces affect them. An economy on the other hand is composed of agents who both perceive their situation and are capable of changing their behavior in response to it. This suggests the notion of a complex adaptive system (CAS) in which the agents are active participants. The behavior of a CAS is much more difficult to study, yet reflection suggests that a modern economy is almost surely a CAS, so this is a task which must be undertaken if we are to make progress understanding financial crises. Foster (2005) has developed a useful taxonomy for complexity systems. He identifies four types: (1) First-order (imposed energy) – Found in inanimate settings when energy is imposed on chemical elements. Characterized by fractal patterns, butterfly effects, etc. Can be modeled with dynamical mathematics. This is the approach Mandelbrot applied to financial prices. The agents react passively, so this is a complex system. (2) Second-order (imposed knowledge, acquired energy) – Found in organic settings. Plants and animals receive imposed (genetically encoded) knowledge and also gain knowledge from experience. All of this gets translated into a knowledge structure that permits some control over energy acquisition. Agents both react and adapt to their environment, so this is a CAS. (3) Third-order (acquired knowledge) – Agents interact not only with their environment but also with images of possible worlds, i.e. mental models. When this happens, some mental models will wind up determining aspects of reality. This is a CAS where “adaptive” involves creativity. If everyone has a mental model of the market and begins associating with their fellow agents according to 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 began interacting with each other. Agents imagine what other agents might be imagining and alter their own models accordingly in a potentially infinite regression. Agents form aspirations and commitments into the future. This type of CAS gets extremely complicated and depends heavily on trust and understanding 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 interest because 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 price changes. The fourth-order type does provide a basis for the behavioral explanation we seek. The problem is that fourth-order complex systems cannot at present be analyzed mathematically. However, though analytical solutions are at present not possible, such systems can be fruitfully studied through simulation methods and through certain types of econometric modeling, as detailed below. The Federal Reserve has become interested in a complex adaptive systems approach to managing financial crises. In the world at large, complex systems abound – weather patterns, tectonic processes, disease contagion, power grids, etc. Their instability 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 experts from fields such a civil engineering, disease control, ecology, national security, and finance discuss their approaches to catastrophe control. The following composite picture emerged: an initial shock (possibly a seemingly insignificant one) leads to a coordinated behavior in the system with reinforcing (positive) feedbacks. A contagion begins, which spreads the original shock. When the pressure becomes too much the system makes a regime shift “from a stable state to an inferior stable state while shedding energy so that it cannot readily recover its original state, a process known as hysteresis” (Kambhu et al., 2007, p. 7). Research is focusing on factors that increase resistance to regime shifts and hysteresis, and on factors than can help the system recover. Some of this research may prove helpful in managing financial crises. 5.4 Evolutionary economics If an economy is a complex adaptive system, then as time passes it does not just run like an electric motor; its form and structure evolves. The machine is the metaphor of the general equilibrium economy; for the complex adaptive system economy, the metaphor is the living organism. It is not easy to model an evolving economy using the neoclassical model, which can accommodate growth fairly readily but structural change only with great difficulty. In a neoclassical model of an evolving economy based on past history, the parameter values are always becoming obsolete – slowly and steadily sometimes, or very quickly when there is a structural shift. The field of evolutionary economics has emphasized these issues for some time and has made efforts to incorporate capacity for structural change into its models. Schumpeter’s idea that creative destruction is the essence of capitalism forms the basis of much modern thinking in evolutionary economics. Schumpeter emphasized the role of liberal credit as a driver of speculative booms, and sudden credit contraction as a major contributor to the severity of the ensuing crash (Leathers and Raines, 2004). The version of evolutionary economics which appears most useful for analyzing financial

crises is the “Micro-Meso-Macro” framework of Dopfer et al. (2004). This framework centers 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 be cognitive, behavioral, technological, institutional, organizational, sociocultural, etc. Rules may be nested in other rules: we might talk about a motorcycle rule that includes engine rules, tire rules, etc. or a market rule that includes a double auction rule, a fixed-price rule, etc. Rules are carried out (actualized) by microeconomic agents (individuals, families, organizations, etc.). A meso unit is a rule plus its population of actualizations (e.g. the motorcycle meso is the motorcycle rule plus all agents who make, sell, repair, or drive motorcycles). An economic system (assumed to be complex adaptive) is a collection of meso units evolving over time. Macroeconomic behavior is the result of interactions among meso units. Economic evolution is the process by which new rules originate and diffuse through the population: very often this process takes the form of a logistic growth path in the new rule’s meso unit. Structural change occurs when a new meso rule permanently alters the coordination structure of the meso units of the economic system. Over time, creative destruction occurs: new rules are constantly being originated; the successful ones develop strong mesos which displace previously dominant mesos; the weak ones disappear. In this framework, a bubble or crisis in the financial sector would be analyzed as a structural change. Foster and Wild (1999b) have developed a promising econometric methodology for analyzing such structural shifts in terms of the logistic function, and for identifying early warning signals that the macro economy may be about to undergo a structural change. A high priority today is to analyze the international growth of money and credit over recent decades using these techniques. 6. Conclusion: toward a new political economy of financial crisis This 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 scope of this paper to model this financial crisis rigorously; instead the goal has been to suggest the best analytical framework – some of which is “new” as applied to financial crises – that might direct more rigorous modeling. Departing from the neoclassical general equilibrium model and other mainstream approaches, this paper proposes an evolutionary and complex systems approach toward 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 a complex adaptive system, and it was a transition to a new ‘meso structure’ in the language of evolutionary economics. As the econometric research of one of the authors has verified, structural changes in normal money supply and demand relationships occurred in the USA, the UK, and other money centers at this time that were associated with government deregulation, advances in information-processing technology, and other aspects of financial liberalization and globalization (Allen, 1999). Although beyond the scope of this paper to simulate rigorously, most of the trajectories of financial 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 diffusion trajectories” with three self-organizing phases called the “emergent”, “inflexion”, and “saturation” phases. As a result of these structural changes, financial markets absorbed newly-created money-power beyond levels predicted by general equilibrium models, which in turn were used to inflate asset prices and incentivize production or consumption beyond predictions; then, during the bust phase, these variables moved in the opposite direction more than expected including a greater than expected fall in stock and real estate prices and destruction of monetary wealth. Depending on the magnitudes of these transfers and re-valuations of monetary wealth over (how much) time and space in the global system, serious real effects can be produced over time and space. These processes, generally not accepted by mainstream, Marxist, and many other economists, can nevertheless account for what the mainstream has understood as “business cycles”, “debt-deflation crises” including depressions (Fisher, 1933), etc., and what Marxists have understood as crises of “underconsumption”, “overproduction”, and ‘disproportionality’ (Clarke, 1994). The ideologies and institutions of finance, are not only “where the action is” and where differential economic power is determined across the world system, but these institutions are also increasingly key to the sustainability of the current global economic 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 GDP processes, can be modeled with the help of third-order and fourth-order complexity processes – acquired knowledge and interactive knowledge processes, respectively – as discussed in the previous section. Given the “animal spirits” of irrational exuberance or fear, transcendental “laws of compound interest” and no-reserve-requirement money-liquidity creation, etc., interactive mental models drove financial cycles and monetary wealth creation and destruction processes beyond the bounds of general equilibrium to levels that required a breakdown in the equilibrating processes – the boom phase and its accompanying meso structure were unsustainable (beyond 2006 or so), 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 of production, rather than vice versa. As part of this process, central banks and other financial market participants such as offshore banks can in some cases (haphazardly) increase or reduce wealth independently of any initial changes in the production of GDP or other “real” economic prospects. And, this wealth – literally created or destroyed out of thin air (or cyberspace) in some cases – is generally allocated through the arbitrary customs and interest rates concessions of particular social networks. Wealth itself in the global human ecology, in these cases, can thus be derived entirely from “pure social agreement”, depending on how well one can participate in the financial system. A review of the authors’ controversial position as italicized here, especially critiquing it from the Marxist and other philosophical-materialist frameworks, appeared in Review of International Political Economy (1996). To the reviewer, the authors’ approach incorrectly “privileges financial changes vis-a`-vis changes in the real economy (production of value)” (p. 532). Furthermore, to the reviewer, any perceived initial creation and distribution of wealth or “value” that happens in “the thin air” of

financial markets could not be sustained over time without correspondence to supportive GDP activity. In contrast, to the authors, “money is wealth” in the sense that it gives the holder a claim on the entire social product. The “social product” includes not only consumption power and production power, but also the power to direct and control large social processes – such as those that are dependent on (gaining access to) the institutions of government, courts, communications, and so on. The accumulation of monetary assets, or what Marxists would call the accumulation of finance capital, represents a social power claim that becomes a key driver in the evolution of the world system. Once monetary wealth is understood as power claims over the social product, then monetary wealth is “real”, and it is limited only by the degree to which power can be exerted over others. Presumably this limit would only be found in the unlikely event that an all-encompassing global monopoly has maximized its differential power. Recent research in the field of international political economy also treats monetary wealth, or finance capital (as opposed to physical capital or capital goods such as machines and factories) as an accumulation of broad social powers: Drawing on the institutional frameworks of Veblen and Mumford, our principal contribution is to integrate power into the definition of capital. Briefly, the value of capital represents discounted expected earnings. Some of these earnings could be associated with the productivity (or exploitation) of the owned industrial apparatus, but this is only part of the story. As capitalism grows in complexity, the earnings of any given business concern come to depend less on its own industrial undertakings and more on the community’s overall productivity. In this sense, the value of capital represents a distributional claim. This claim is manifested partly through ownership, but more broadly through the whole spectrum of social power. Moreover, power is not only a means of accumulation, but also its most fundamental end. For the absentee owner, the purpose is not to “maximize” profits but to “beat the average”. The ultimate goal of business is not hedonic pleasure, but differential gain. In our view, this differential aspect of accumulation offers a promising avenue for putting power into the definition of capital [. . .]. In the eyes of a modern investor, capital means a capitalized earning capacity. It consists not of the owned factories, mines, aeroplanes or retail establishments, but of the present value of profits expected to be earned by force of such ownership (Nitzan, 1998, pp. 173, 182).

Building on this quote, Nitzan argues that wealth accumulation processes allowed by monetary capital have favored pecuniary business activities and owners over tangible industrial productivity and working consumers. He argues that, increasingly, “the causal link runs not from the creation of earnings to the right of ownership, but from the right of ownership to the appropriation of earnings” (p. 180). This causality is consistent with the writings of Thorstein Veblen, who insisted that the “natural right of ownership” conferred by society to various people (initially to own slaves, then animals, land, and now capital including ever more symbolic monetary forms), can be used competitively to obtain further social powers at the expense of others (Veblen, 1923). To summarize, based upon these issues and frameworks, the authors and others gradually propose “a new political economy of financial crises” (Allen, 2004) – a project that is bound to gain further thrust both conceptually and empirically as analysis of the current crisis proceeds. In the language of evolutionary economics, hopefully this essay has usefully described some of the path-dependent trajectory of this 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 approach to 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 monetary policy”, International Economics and Financial Markets: The AMEX Bank Review Prize Essays, 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.), Finance and 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 Evolutionary Economics, 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 of Economics, Vol. 29, pp. 873-92. Foster, J. and Wild, P. (1999a), “Detecting self-organizational change in economic processes exhibiting 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 the market for liquidity”, in Feldstein, M. (Ed.), The Risk of Economic Crisis, The University of Chicago 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 Systemic Risk: A Report on a Conference Co-sponsored by the Federal Reserve Bank of New York and the 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 of payments 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 Public Finance, Vol. 6 No. 4, pp. 459-72.

Krugman, P. (1999), “Balance sheets, the transfer problem and financial crises”, Journal of Money, 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 the new 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”, Review of 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 eight centuries 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 of America, introduction by Robert Leckachman, Beacon Press, Boston, MA (reproduced 1967). About the authors Roy E. Allen is Professor of Economics and Dean in the School of Economics and Business Administration, Saint Mary’s College of California. His recent books are Human Ecology Economics: A New Framework for Global Sustainability (as editor, Routledge, 2008) and Financial Crises and Recession in the Global Economy (Edward Elgar, third edition forthcoming 2009). His research interests include globalization, sustainability studies, financial systems, and use of the humanities to gain critical insights into the functioning of the economic system. Roy E. Allen is the corresponding author and can be contacted at: [email protected]. Donald Snyder is Professor of Business Administration in the School of Economics and Business Administration, Saint Mary’s College of California. His most recent publication is “Strange priors: understanding globalization” (in Human Ecology Economics: A New Framework for Global Sustainability, Routledge, 2008). His research interests include evolutionary and complex systems among other ways to model the economic system, economic growth and development, globalization, and financial market dynamics.

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School of Business and Government, University of Canberra, Canberra, Australia Abstract Purpose – This paper aims to examine the current financial crisis, suggesting that most analyses have attributed the crisis to a lack of business ethics, the rise of greed and lax regulation. Prescriptions offered 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 that such business practices have their roots in an extreme political and economic ideology – neoliberal market fundamentalism. This paper seeks to suggests that a greater appreciation of the nexus between politics, philosophy and economics is critical in order to develop a different practice. As such, the author provides a socio-historical and political context for understanding the present crisis before offering a critique and reform of the business educational agenda. The author argues that such a context would engender greater understanding of business practices and systems for both students and practitioners and would go some way in enabling them to fashion a more critical reflexive and engaged practice. Design/methodology/approach – The paper draws on a critical-historical review of the literature on the crisis. In so doing, the paper opens up the analysis to philosophical and political approaches to understanding financial crises. Findings – The paper finds that explanations for the crisis can be found through a critical appreciation of philosophical and political texts. This finding also suggests that current business and management education and practices can benefit from an incorporation of these historical strands of thought. 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 paper also finds that a richer and deeper appreciation of the crisis can be found through a critical-historical positioning of the crisis. This necessitates an understanding of politics and philosophy in business practices and education. Practical implications – In explaining the crisis, the paper suggests that many of the current financial “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 for understanding international economics and business practices. This reflexivity is often missing in international business studies and most management practices. Keywords Political economy, Recession, Politics, Capitalist systems, Education, United States of America Paper type Viewpoint

critical perspectives on international business Vol. 5 No. 1/2, 2009 pp. 56-77 q Emerald Group Publishing Limited 1742-2043 DOI 10.1108/17422040910938686

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

2008, Bank of America announced it was buying out Merrill Lynch, one of the world’s most famous investment banks; on the following Monday, Lehman Brothers, the fourth largest securities firm in the USA, filed for bankruptcy; and, on Tuesday, the US Federal Reserve invested $85 billion in a takeover of AIG, America’s largest insurance company. More recently, on Thursday, 25 September, the huge US bank Washington Mutual, in a state of collapse, was taken over by JPMorgan Chase, in a move described as “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 of world capitalism, as it plunges into the deepest slump since the 1930s. Five European banks have collapsed in as many days. Despite the $US700bn bailout, the crisis continues unabated. The German government was forced to intervene to bail out the real estate giant, Hypo, amid growing panic in the financial sector. BNP Paribas was forced under Belgian government pressure to take over Fortis’s operations in Belgium and Luxemburg. This followed the decision of The Netherlands government to nationalise Fortis in The Netherlands. Turmoil has also hit France, where Caisse d’Epargne is likely to merge with Banque Populaire, and Italy, with Unicredit going under. In Iceland, the economic crisis has forced the government to nationalise one of its biggest banks, Glitnir, while a large investment house collapsed; the authorities also drew up sweeping powers to nationalise banks and sack executives as the country faced bankruptcy. The krona fell as much as 45 per cent against the euro, as the country 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 crises go, we are now in the big league. Comparisons with the dotcom bubble or even the Asian crisis 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 equities seemed the prelude to a downturn in the real economy. But the real world sailed on, and other asset classes were largely unscathed. Compared to 1929, there are two main differences today. First, world policy makers have grasped 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 of date 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 either filed for bankruptcy, been “bailed out” by the government, or been nationalised. Most economists do not know the depth and extent of the loss. As Dominique Strauss-Kahn writes in the FT: But with much of the losses yet to be realized, and with the financial crisis now acute, it has become clear that nothing short of a systemic solution – comprehensive in tackling the immediate fallout and comprehensive in addressing the root causes – will permit the broader economy, in the US and globally, to function with any semblance of normality (Financial Times, 22 September 2008).

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

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remembered as the time the U.S. government discarded a half-century of rules to save American financial capitalism from collapse”. For years the USA economy appeared to be defying the laws of economic gravity, going up and up. However, its present fall is more spectacular and is far from over. The crisis has clearly spread from the financial sector to the rest of the economy. The difference with 1929 is that the world is far more interdependent and the scale of the crisis is potentially far bigger. All the factors that developed the boom over the past 20 years are now turning into their opposites. The profits bonanza has crashed. The market is contracting rapidly. Consumer spending is falling. The FT opined: “We are now, unquestionably, in the worst financial crisis since 1929. We do not know how many more banks and institutions will fail – Washington Mutual, the US counterpart of HBOS, is under severe pressure – but Bear Stearns, Fannie Mae and Freddie Mac, Lehman and AIG are plenty” (Financial Times, 19 September 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). Banks and financial institutions are weighed down by huge losses caused by “non-performing loans”. Lending channels are choked up, as lenders are being called to pay back their loans, to clean up their balance sheets, and fearful that they are “throwing good money after bad” and will not be paid back. There is real danger of a breakdown of the financial system. The new president of the International Monetary Fund has stated that 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 cascading failures throughout the world. Big firms are so interlinked with one another and with other market players that the failure of one large counterparty, as they’re called, can drag down counterparties all over the globe. And if the counterparties fail, it could down the counterparties’ counterparties, and so on (Sloan, 2008).

In this paper, I seek to position current academic reflexive comments on the present global crisis. Some have commented on the inadequacy of management and business education, 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 a battle between capitalism and socialism. I therefore turn to a recent piece in the Financial Times which seeks to contextualise and position Marx within our understanding of the present crisis. I next examine critically the work of Marx and show how it enables us to frame the present crisis before examining the current phase of neoliberal capitalism and the rise of finance capital. Free market economist Martin Wolf sees the crisis as one arising from the mutation of capitalism from “mid-20th century 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 be termed ‘monopoly-finance capital’” (Foster, 2007, p. 1). The paper next discusses the responses to the crisis and argues that unless fundamental reforms are introduced, including an injection of politics within business education and our practices, the crisis will recur again in the future.

The MBA, the crisis and Marx Not many MBA courses include the reading of Marx’s Capital. Not many CEOs could quote from The Communist Manifesto. But there are times when it pays even the most passionate believers 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 himself would have preferred to call it a “crisis of capitalism”.

So wrote Niall Ferguson, Professor of Political and Financial History at Oxford and Visiting 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 can still illuminate [. . .] Marx got one thing right. Behind the bubbles and busts of the capitalist system there is a class struggle; and that class struggle is the key to modern politics”. He went on: “This may read like heresy, especially in the pages of the Financial Times”, said Ferguson, somewhat on the defensive. “But a little reflection on the current crisis of capitalism will show otherwise. Not that today’s class struggle bears much relation to that of Marx’s day”. In fact, says Ferguson, there is “a conflict within the bourgeoisie” where “the history of capitalism is the history of expropriation and the concentration of wealth – the means of production – in the hands of an ever-decreasing minority [. . .] widening inequality and globalisation”, making capitalism 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 capitalist economy, the United States. In 1981, the top 1 percent of households owned a quarter of American wealth; by the late 1990s, that single percentage owned more than 38 percent, higher than at any time since the 1920s”. Commenting on the present crisis, he noted that “The global implications of a slowdown in the vast American economy are alarming. The other key element of the late-90s bubble was the willingness of foreign investors 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 the dollar exchange rate threatens to make those losses even bigger. If the experience of the 1980s is anything to go by, the dollar could fall steeply as foreign investors sell off. The resulting reduction of American imports would further hurt the rest of the world”. He went on to advise us that we should not “prepare for the death-knell of capitalism just yet” and that there was good news: the US stock market has simply retraced its steps back to mid-1997, the USA is free from the spectre of inflation, the American financial sector is in far better health than its Japanese counterpart, and above all, the Fed is not the Bank of Japan. For him, we should relax: “the recession was last year, and you barely felt it. This is the kind of crisis of capitalism Argentineans can only dream about”. For him, there are lessons to be learnt and “It is the social structure of American capitalism that is in real need of attention”. In Ferguson’s analysis, the primary culprit is 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, for example the lack of regulation and the lack of transparency was glaring as risks were undetermined (Walker, 2008). Others have castigated the US economy for its “monstrous bubble of cheap credit [. . .] with one bubble begetting another” – in the words 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 real economy they have infected”. Household debt has risen to 133 percent of disposable personal income, while the debt of financial corporations has hit the stratosphere, and government and non-financial corporate debt have been steadily increasing (Roach, 2007). This huge explosion in debt – consumer, corporate, and government – relative to the underlying economy (equal to well over 300 percent of GDP by the housing bubble’s peak in 2005) has lifted the economy, created an appreciation of assets and wealth, and leads to growing instability. This was brought about as investors began to realise that a large proportion of the debt securities that they were trading were based on sub-prime mortgages that were never going to be paid back. The banks had supposedly discovered how to limit their own exposure, while raking in the charges, by repackaging poor debts as CDOs (collateralised debt obligations) and selling them on to their clients, in ways that supposedly spread and insured the risk. More fundamentally, a second, huge financial system based on banks borrowing from other banks to buy equities (the general term for assets traded on financial markets) on the basis that the value of these equities would continue to rise indefinitely, developed outside the normal banking network (Shiller, 2008). It was unregulated, not transparent and way too leveraged. If these equities begin to fall in price, the huge debts of these banks become exposed, and the contradictions in the system become apparent[2]. The spectre of Marx In their article “Production and finance”, Magdoff and Sweezy (1983) argued that that the normal path of the mature capitalist economies, such as those of the USA, the major Western European countries, and Japan, is one of stagnation rather than rapid growth. In this perspective, today’s periodic crises, rather than merely constituting temporary interruptions in a process of accelerated advance, point to serious and growing long-term constraints on capital accumulation. They saw financial explosion as a response to the stagnation of the underlying economy, helping to “offset the surplus productive capacity of modern industry”. A capitalist economy in order to continue to grow must constantly find new sources of demand for the growing surplus that it generates. That’s why, for example, money jumps into Thai real estate markets one day, and pulls out and goes into ethanol production in Brazil the next . . . and then back to mortgage securities. And there is something else: the inflows and outflows of short-term and speculative capital also act as a perverse means of imposing discipline on and restructuring capitals – a major manufacturing firm can be starved of credit or threatened with a leveraged buyout. And this kind of “financial discipline” has been imposed on whole countries in the Third World (Rude, 2004). All this is part of the reason that financial instability is a constant feature of capitalism in its more globalised and financialised forms of existence. There comes a time, however, in the historical evolution of the economy when much of the investment-seeking surplus generated by the enormous and growing productivity of the system is unable to find sufficient new profitable investment outlets[3]. In recent months, the spectre of Marx has been revived. Marxists claimed that these contradictions were anticipated by Marx. Whilst Marx was never able to complete a theory of crisis in his lifetime (volumes II and III of Capital remained unfinished when he died), Marxists traditionally link capitalist crisis to the tendency of the rate of profit

(surplus value extracted per unit capital invested) to fall over time. In order to deduce this tendency, Marx divides this “unit capital invested” into two parts: (1) constant capital, which invested in the production process (e.g. the plant, raw materials etc.); and (2) variable capital, which is invested in staff wages. Surplus value can only be extracted from workers, not machines. Surplus value is the value of the labour given by a worker above and beyond that which is paid to him or her as wages; hence it is the source of profit for the capitalist. Therefore, increasing the constant capital, for example, by investing in new machinery, whilst doubtless improving 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 of profit will fall. This manifests itself as a fall in prices of commodities (think about how the price of electronic goods falls over time). Of course, this tendency is not a law – there are other interacting factors which can cause 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 the rate of profit to fall represents a huge contradiction in the capitalist system: competition forces capitalists to increase constant capital (by investing in new technology, for instance), which leads to an ever-diminishing rate of return on that investment. However, this current crisis originated in the financial sector, which in this current epoch dominates world capitalism. According to Marx, capital agglomerates and seeks greater returns and a higher rate of profit. This growing concentration for Marx leads in 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 more capital under the control of fewer and fewer capitalists, tending to monopoly) is a driving force behind falling rate of profit, and how this falling rate of profit drives capitalists to seek profit through speculation, in effect making “free money” through trading bits of paper. This increase in share capital, claims Marxists, can counteract the tendency of falling rate of profit. In the age of huge monopoly capitalism, where 500 companies control 45 percent of the world’s economy, it is hardly surprising that it is increasingly hard to turn a large profit without engaging in “risky” financial activities (i.e. without gambling other people’s money) – credit, shares, derivatives and other assets. In this carnival of money-making, the banks lent vast sums of money and vastly over extended their loans, especially in the property market[4]. But boom turned inevitably 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 the crisis that causes a lack of money. When the economy enters into crisis, credit dries up and people demand hard cash instead. This is the effect of the crisis, but in turn it becomes cause, pushing down demand and creating a downward spiral. Bankers and governments insist that the cause of the crisis is the fact that the financial system has too little capital. Clearly if we look at the last two decades, banks have been and are continuing 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 surely be incredulous for banks to claim they do not have enough capital. Actually, there was a huge amount of loan capital in circulation during the boom, and this superabundance of 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 were being made and investors were happy, nobody cared. Let us take just one example: the credit default swap industry. This market allows two parties to bet on the likelihood of a company defaulting on its debt. It has grown to about $90 trillion in notional amounts insured – that is to say, probably more than double the total outstanding credit in the world. But contracts are registered nowhere but in the books of the partners. Nobody knows the real volume of trading, which therefore exposes the world economy to a huge 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 of international finance crashing down, with unforeseen consequences. Unless and until all the bad assets are removed, many institutions will still lack sufficient capital to extend fresh credit to the economy. Marx described this stage in the economic cycle long ago: That means of payment are scarce during the period of crisis goes without saying. The convertibility of bills of exchange has substituted itself for the metamorphosis of commodities themselves, and so much more so at such times, as a portion of the firms operates 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 a system of production, in which the entire connection of the reproduction process rests upon credit, a crisis must obviously occur through a tremendous rush for means of payment, when credit suddenly ceases and nothing but cash payment goes. At first glance, therefore, the whole crisis seems to be merely a credit and money crisis. And in fact it is but a question of the convertibility of bills of exchange into money. But the majority of these bills represent actual sales and purchases, and it is the extension of these far beyond the needs of society which is at the bottom of the whole crisis. At the same time, an enormous quantity of these bills 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 can never more be realized. This entire artificial system of forced expansion of the reproduction process cannot, of course, be remedied by having some bank, like the Bank of England, give to the swindlers the needed capital in the shape of paper notes and buy up all the depreciated commodities at their old nominal values. Moreover, everything here appears turned upside down here, since no real prices and their real basis appear in this paper world, but only bullion, 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, on credit, and that “the solvency of one link in the chain depends upon the solvency of another”. The chain can be broken at numerous points. And that sooner or later, credit must be paid off in cash. This fact, for Marxists, is all too frequently forgotten by those who become indebted during the process of capitalist upswing. In the first phase of capitalist expansion, credit typically acts as a spur to production: “the development of the productive process extends the credit, and credit leads to an extension of industrial and commercial operations” (Marx, 1909, vol. 3, pp. 563-5). This has a tendency to push

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 to enforce. Marx’s views are not so different from the recent work of Thomas Palley (2007). In his paper, “Financialization: what it is and why it matters”, Palley notes that “the era of financialization has been associated with generally tepid economic growth. [. . .] In all countries except the U.K., average annual growth fell during the era of financialization that set in after 1979. Additionally, growth also appears to show a slowing trend so that growth in the 1980s was higher than in the 1990s, which in turn was higher than in the 2000s”. He goes on to observe that “the business cycle generated by financialization may be unstable and end in prolonged stagnation”. Nevertheless, the main thrust of Palley’s argument is that this “prolonged stagnation” is an outgrowth of financialization rather than the other way around. Thus he contends that such factors as the “wage stagnation and increased income inequality” are “significantly due 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 from financial bubbles. Thus “financialization may render the economy prone to debt-deflation and prolonged recession”. Palley calls this argument the “financialization thesis”[7]. Neoliberalism and financialisation For the past quarter of a century, neoliberalism, sometimes called market fundamentalism, the policy of non-intervention in the economy, has been the ideology, and the set of policies that go with it. Now the economic crisis is forcing the authorities to intervene, regulate, and even nationalise firms. Is neoliberalism dead? Martin Wolf, economic guru of the Financial Times, suggests the neoliberal rulebook needs to be torn up. He dates the change from the collapse of Bear Stearns last March. “Remember Friday March 14th: it was the day the dream of global free-market capitalism died. For three decades we have moved towards market-driven financial systems. By its decision to rescue Bear Stearns the Federal Reserve, the institution responsible 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 Joseph Ackerman, chief executive of Deutsche Bank that, ‘I no longer believe in the market’s self-healing power.’ Deregulation has reached its limits”. As the crisis bit into the popular consciousness, the popular press recorded the same thought. The Daily Express (DE) headline screamed, “Don’t let the spivs destroy Britain” (Daily Express, 17 September 2008). The article began, “Millions of British families are facing the destruction of their livelihoods as the nation’s economy teeters on the brink of catastrophe, brought low by the greed and stupidity of spivs in high finance”. Here, greed and Gordon Gekko is the cause but clearly not compelling or persuasive enough. Many of these policies have their roots in the 1970s and the emergence of a new neoliberal ideology. In 1973-1974 we saw the first generalised crisis of world capitalism. The preceding period from 1948 to 1973 was seen to be a golden age 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 the perception was that capitalism had changed fundamentally. Booms and slumps, it was generally 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 internationally mobilised 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 a result of this clash, a revolutionary wave swept across the capitalist world. All the earlier certainties were thrown up in the air and called into question. In addition to rapidly rising unemployment the world economy experienced spiralling prices. The immediate trigger for inflation was the oil price crises of 1973 and 1979. Never before had we experienced inflation together with recession. This was called stagflation and in its wake neoliberalism was spawned. Associated with neoliberalism was “globalisation”. Tariff barriers were coming down all over the globe. Capital was expanding everywhere and everything was “deregulated”[8]. Its proponents argued that “globalisation” meant that resistance was futile. Because capital was endlessly mobile, nation states were becoming powerless. They had to reduce taxes on profits and obey the multinationals’ every wish or they would simply move their money elsewhere. Workers would be “blackmailed” into accepting lower and lower wages or they would lose their jobs altogether. It was a race to the bottom[9]. Neoliberal triumphalism received a further fillip as the Soviet Union collapsed and capitalism, it was claimed, had won the Cold War! So it seemed there was no alternative to capitalism (or “the market”, as apologists came to call it) and its proponents proclaimed “the end of history” (Fukuyama). Movement of money used to be analysed in terms of trade. For example, in buying a kilogram 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. By 1990, banks were creating “structured investment vehicles” and other derivative assets to bypass the reserve requirements of the Basel Bank regulations. The assumption was that geographical and sector dispersion of the loan portfolio and the “slicing and dicing” of risk would convert all but the very lowest of the tranches of these investment vehicles into safe bets. It also led to the blurring of the lines between commercial and investment banking, insurance and real estate in the FIRE (finance, insurance and real estate) sector. This led to financial innovative packages enabling high leveraging of funds accessible through low interest loans[10]. As a Financial Times report put it at the close of 2007: While investors are scrutinizing some of the industry’s best-known names, a spectre will be silently haunting events: the state of the little known, so-called “shadow” banking system. A plethora of opaque institutions and vehicles have sprung up in American and European markets this decade, and they have come to play an important role in providing credit across the system (Tett and Davies, 2007).

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

production. For globalisers, the explosion of global financial flows shows capitalism has at last created one world. More importantly, it increased their powers and spheres of operations: from their traditional underwriting and brokerage, from mergers and acquisitions (M&As) and initial public offerings (IPOs), from proprietary trading and risk arbitrage; and from positioning themselves and their clients in relationship to the wider impact of a merger or some other major event, enabling them to gain from changes in relative prices whether or not a deal goes ahead. In lifting themselves from space (territory), corporate activities now also seek to supersede the temporal dimensions; for example, vast funds can now be shifted in nano-seconds and central banks have little control over their exchange rate, which is mainly driven by the market. Globalisers argue that “market forces” are now sweeping all before them. Now, the globalisers 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 state is itself an economic actor, a power affecting economic behaviour. As Bukharin points out, “The fact is that the very foundation of modern states as definite political entities was caused by economic needs and requirements. The state grew on the economic foundation; it was an expression of economic connections; state ties appeared only as an expression of economic ties” (Bukharin, 1929, p. 63). He goes on: “The stronger state secures for its industries the most advantageous trade treaties, and establishes high tariffs that are disadvantageous for the competitors. It helps its finance capital to monopolise the sales markets, the markets for raw materials and particularly the spheres for capital investment” (Bukharin, 1929, p. 137). This state of play – the interaction between economic power and state power – is still a central feature of modern economic rivalry, but in the light of the crisis, all has changed. Governments now intervene to stop the markets from collapsing and indeed, bailouts have been the order of the day. As Sutherland observes: “In the US, hundreds of billions of dollars of banking risk will be transferred to the federal government, adding to America’s huge burden of debt and increasing its reliance on foreign investors [. . .] Policymakers now face formidable challenges: fighting the fire, then repairing the financial system while keeping a lid on inflation, then putting in place effective new regulation”. For her, the worst is yet to come. She goes on, “This crisis should prompt us to reappraise our relationship with money and debt, and to think hard about how we can create a fairer and more inclusive version of capitalism. There should be no return to the market’s false 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 abundantly clear that voluntary regulation does not work. This has been echoed by European leaders, including President Sarkozy Agreeing with this sea change in consciousness. “[The] idea of an all powerful market without any rules and any political intervention is mad”. 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 is always right is finished’. Vladimir Putin, Russia’s Prime Minister, sees this as an American 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 system that claims leadership.

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Others similarly agreed: “The origin and centre of gravity of the problem is clearly in the USA”, German finance minister Peer Steinbru¨ck pronounced. And Gordon Brown, prime minister of UK, said his nation’s economic problems were imported from America, a view shared by opposition leader David Cameron (Stelzer, 2008). This is all trenchant criticism – unprecedented for a generation. Their outrage is directed at financial “geniuses” they now realise were simple charlatans, who have been helping themselves to the good things in life at our expense and landing us all in the mire in the process. Their call is for regulation. Capitalism, we are told, would be a good system if only it were adequately regulated. In ‘A shattering moment in America’s fall from power’, John Gray (2008) argues that “It is America’s political class that, by embracing the dangerously simplistic ideology of deregulation, has responsibility for the present mess”. In the same issue of The Observer, Richard Wachman writes under the headline, “This transforms the financial system. Forever”. He sums up his argument: “US power is ebbing away and free market fundamentalism is an outdated ideology”. Forever is a long time in politics. It is true that the USA is running a huge deficit with the countries it trades with. This is surely a sign of economic weakness. The country is up to its ears in debt to the rest of the world. The dollar is derided. US hegemony is weakening. Is it still the one, unassailable economic superpower? The real questions remain: (1) What is the real relation between capitalism and regulation? (2) What other country can lead the capitalist world and impose the norms and principles without which it cannot function? Capitalism will always go through cycles of boom and slump. But the 1929 Wall Street Crash led directly to the Great Depression, the worst capitalist slump so far. Economist Charles Kindleberger sought to answer the question why the Great Depression was so deep and so widespread in his book The World in Depression 1929-39. His explanation was that the slump was so severe and long-lasting because there was no international lender of last resort. We do not believe this offers a complete explanation for the disastrous decade, but it is an important aspect of the truth. Before the First World War Britain was regarded as the hegemon and acted as the lender of last resort. The gold standard was really the sterling standard. The war showed that British hegemony was under decisive challenge. After the Second World War the USA asserted its supremacy under the Bretton Woods Agreement, which determined the terms of world trade. It imposed the dollar as de facto world currency. And it had the power to act as international lender of last resort. Between the wars the USA was the most powerful capitalist nation, but it did not impose its power upon the world economy, remaining isolationist. This international anarchy led to “beggar-my-neighbour” devaluations and the virtual drying up of world trade. This impacted in turn on the economies of every nation on the globe. Now US hegemony is under challenge, but no clear alternative is in sight. If Kindleberger’s analysis of the 1930s is right, and we are entering a similar era today, then we are in for stormy times.

Reforms and the big picture It has been argued that the present crisis is the result of regulatory failure to guard against 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 happen again”. At its core are a number of fundamental questions: the issue of business practices (which includes the practices of management, greed, business ethics and management education) and that of regulation, particularly the role of the state in effecting such regulations. The latter is particularly telling and ironic given that most economists and commentators have argued precisely the opposite: that all regulations were bad for business and should be abolished (this was particularly advocated for the financial sector). The market, its proponents claim, would deliver the right and most efficient outcome and wealth was unbounded. Similarly, present calls to ban (temporarily) the practice of “selling short” are unrealistic. In order that the markets can function, it is necessary for people to buy and sell shares, and they must do so on the basis of estimating whether the share price is going to rise or fall. The idea that it is permissible 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 seen in the wake of the present crisis attempts to redress the capital-society-labour relationship. Regulating the share market, curbing excessive bonuses and regulating boardroom pay, minimising risks for speculative activities and ensuring security for these 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 the economy more stable or provide greater equality, but rather provides conditions for greater speculation as speculators can now depend on government bailouts or their decisions. Whilst laws and regulations can be enacted, reining in greed and regulating boardroom pay is patently not feasible; how and by what mechanisms are these practices to be performed? Similarly, the (re)regulation of the finance sector and governmental interventions in the sector do not constitute a radical change[12]. In the past, states’ entities were highly involved in financial transactions and they was highly regulated. What has transpired is the reemergence of the state in managing fiscal crises engendered 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 has been brought back in to enforce fiscal discipline. This requires the state to protect the interest of vested interests by giving them vast subsidies, paid for out from state revenues[13]. Speculators and bankers are rewarded for their nefarious activities by the state, which buys up all their losses, then spends further vast amounts of the taxpayers’ money to make them profitable, and when discipline has been restored, to sell 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. The idea that this can be controlled by governments and central bankers is nonsense. On the contrary, the uncontrollable nature of capitalism has never been more apparent than at the present time. Moreover, the unprecedented intensification of the concentration of capital, where vast amounts of capital (much of it fictitious) are moved about the world at the caprice of a small number of people, lends the whole process an even more convulsive and unpredictable character. The present nervousness on world stock 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 are witnessing now is that a particular dynamic of growth, marked by intensified financialisation, is generating new contradictions and new barriers to sustained accumulation. Here we come to a basic point of this analysis: a financial crisis has broken out because of the severe imbalances built up between the financial system – and its expectations of future profits – and the accumulation of capital; that is, the structures and actual production of profit based on exploitation of wage-labour. The state is intervening to head off further damage and to discipline and restructure the financial system. But the very complexity of the “financial packages” created during the speculative boom – with their bundled-up loans and long strings of finance – are producing new challenges for policy-makers. As one Yale economist put it, perhaps unintentionally echoing a phrase from Marx: “like the sorcerer’s apprentice, we have created 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 market recently eclipsed the US market in size. China’s growing demand for raw materials to fuel its export economy is making it a new player in the scramble for resources and control over them. And China’s increasing importance as a supplier of capital to the USA 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 is severely hobbled – and this includes its ability to stimulate the economy through fiscal and monetary policy. The USA has never run such large current account deficits and no single country’s deficit has ever bulked as large relative to the global economy. The present crisis clearly foreshadows changes in geo-economic and geopolitical realities and may signal the passing of a great power and the emergence of a “new” power. It will also, in the short term, usher in a new regime of global governance and (re)regulation of financial markets. Maybe, business schools and international business practitioners can also revisit basic principles of economics and explore the relationships between economics, philosophy and politics again. Lessons learned As I have indicated, the present crisis provides us with an opportunity to reflect critically on business practices, including management education. As academics, some of us have been guilty of presenting simple, linear solutions to our students. We privilege quantifiable measures and success is determined by these measurable performance indicators. This is abundantly clear in courses in finance, strategic management and finance, particularly in MBA and executive education. Most MBA programs rely on American textbooks and case study materials, and they continue to constitute the international benchmark which typically reproduces this “American” standard and ethos (Liang and Wang, 2004). Of late, the quality of MBA programs has been 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 has condemned MBA programs as promoting formulaic, generic, “cookie-cutter” responses to business management issues and practices, rather than training people involved to

manage (Pfeffer and Fong, 2002, 2004). For Mintzberg and his colleagues, education makes the issue of management worse if it merely involves a reproduction of the insubstantial knowledge and skills offered (Gosling and Mintzberg, 2006; Mintzberg and Gosling, 2002). Ghoshal (2005) similarly opines: Business schools do not need to do a great deal more to help prevent future Enrons [. . .] They do not need to create new courses [. . .] Our theories and ideas have done much to strengthen the management practices that we are all now so loudly condemning (Ghoshal, 2005, p. 75; see also Pfeffer and Fong, 2002, 2004). In focusing on being scientific, developing models and techniques rather than the development of diagnostic capabilities, the MBA has become too instrumental and renders analysis simplistic. In the process, the MBA produces “critters with lopsided brains, icy hearts and shrunken souls” (Pfeffer and Fong, 2002, p. 80).

This concentration on models, financial indicators and performance and the lack of reflexivity within the MBA means that many managers simply do not develop or have the 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 Master of Fine Arts) may in fact be of more value than the MBA, because they promote creative, innovative, “out-of-the-box” thinking and conceptualisation of problems. Business leaders have similarly echoed such sentiments, noting the dearth of critical and creative thinking (Andrews and Tyson, 2004; Doria et al., 2003). Despite these criticisms, “MBA fever” has shown little signs of abating. Indeed, executive education, MBA and business education in general have all been criticized for its simplicity, positivity and linearity. Financial measures have all been overly privileged and short-term performances are lauded and celebrated through record financial profits. Business strategies and plans typically rely on a planning or design scenario but as the crisis shows, such approaches are inadequate; they do not provide us with real-time information nor are they are complete. They also certainly do not take into account the dynamism inherent in market practices, and cannot factor in for example some behavioural practices, the run on credit, confidence quantum and herd behaviour. Equally problematic is the reliance on market solutions to “regulate” the economy. Indeed, many aspects of our “efficient” capitalism combined to produce the credit meltdown that now threatens ever more aspects of the global economy. First and foremost was the private rating companies’ failure to accurately assess and honestly reveal the risks of securities based on a “bundle” of loans (securities that provide their owners with a portion of that bundle’s principal and/or interest). This was especially true for securities based on mortgage loans issued in the years of the housing boom. Investors around the world bought those securities based on those companies’ ratings. Their purchases financed the US housing bubble. We know now that those ratings were badly mistaken. Owners of those securities around the globe are taking staggering losses and reducing their lending to all borrowers. Anxiety about the risks of all sorts of borrowing has risen alongside deepening distrust of all risk assessments. Understanding why the rating companies contributed to this disaster opens a crucial window into today’s global credit crisis. It also teaches basic lessons about today’s globalised capitalism. Since the crisis, it has become abundantly clear that global financial structures and systems are arcane and inadequate. Its structures are unsophisticated and management incompetent. The presumed sophistication of bank risk-assessment models 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, these techniques were used mainly to reduce uncertainty and hedge currency risk, to shape a trade limiting their exposure to the level in which the trader has confidence. Derivatives, such as swaps, options and other financial instruments, are used as tools limiting such exposure (Buenza and Stark, 2004; Tett, 2007). Again, this practice points to the effects of one-dimensional reliance on economic and financial modelling techniques, that is, as useful as they are, they are limited and cannot possibly account for the range of human responses and dynamism within complex business social environments. In part, this is because the prospects of a given stock cannot be distilled in a single figure since the balance sheet of an enterprise will always comprise a complex of receipts and liabilities in which the past, present and future uneasily coexist. This is highly complex, interactive and reiterative; the deregulation of financial markets also further increased this “complexity” (Ingham, 2004). Moreover, with financial data, there is often a problem of a sample size that is not large enough to capture their variance over a significant time period. In a long-term perspective the information available to someone basing themselves on today’s financial data is very limited; by excluding the future, it is impossible to estimate and determine the future[14]. Second, we need to grasp the structure of the financial industry and the concomitant industry that sells assessments of the risks attached to securities (including those based on loans). Even the most powerful corporations need the financial world to assess 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 determined by banks and ratings agencies, especially if they wish to reassure investors and ensure cheap access to capital (Sinclair, 2005). Of the 150 rating enterprises around the world, three dominate – Moody’s, Standard and Poor’s and Fitch. Barron’s Magazine (Laing, 2007) reported on a Morgan Stanley research report which studied the 6,431 subprime residential mortgage-backed securities issued in 2006. Of these, 2,087 issues were rated AAA (the highest rating, the lowest risk); 1,266 were rated AA; and the rest were rated A or lower. Within one year of being issued, most of these securities were re-examined by the rating companies and over 50 per cent were downgraded, i.e. given a new, lower rating[15]. Clearly there was a problem with the ratings and the methodologies employed and whilst they could not be held solely for the crisis, they “were key enablers, by countenancing and legitimizing 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 that what 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 the worth of financial institutions’ balance sheets. Clearly, therein lies in the problem of reliance solely on indicators which were provided by firms themselves and which were, in themselves, dense, incomplete and inadequate. The complexity of the deals and the relationships between the different logics of financial instruments were not well understood and certainly had grave unintended consequences. It is apparent that “independent risk assessments” are inadequate and ineffective. Years ago, when huge losses flowed from securities whose

issuers had misrepresented their risks, the reformist demand arose that someone should “independently” assess their risk so investors would be honestly informed. It turns out now that providers of such independent assessments can misrepresent them as disastrously as their issuers did and do. More fundamentally, it reveals a blinkered ideology – market fundamentalism – at work. For example, Alan Greenspan in addressing the Futures Industry Association in March 1999 insisted that any new regulations on derivative products “would be a major mistake”: “Regulatory risk-measurement schemes”, he added, “are simpler and much less accurate than banks’ [own] risk-measurement models” (Schwartz and Creswell, 2008). Appearing recently before the US Congress, Greenspan admitted to having made mistakes, being an 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 be struck down. Financialisation, as I have indicated, privatises information that should be public, just as it commercializes everyday life. In addition, the techniques of financialisation could convert one type of income stream into another, or an asset into income or the other way round – reducing or avoiding tax. There are already calls for proper regulation and registration of these instruments. Would governments and regulation do any better? I think not. It is worth recalling that financialisation was born in a quite heavily regulated world, with some of its techniques designed to frustrate and defeat the regulators, just as others aimed at releasing “value” (Tett, 2007). As such, as a first step, the clauses of Basel II that allow banks to use their own valuation models need to be struck down before we address other pressing issues. Most prescriptions for more regulation call for a new regulatory order where the state is a more active agent. This involves a network of mechanisms designed to constrain collective outbreaks of financial imprudence before they become global. For example, it has been suggested that there needs to be a new system of globally coordinated financial regulation (Eatwell and Taylor, 2000). How and what this new regulatory framework should do, however, remains unknown for the fundamental problem remains: full and complete information, transparency and greater democratic accountability, to which the corporate sector will not readily agree[16]. Governments similarly would not be able to provide such access as privacy and commercial information enables corporations to “protect” such information. We need therefore to be more sceptical of merely pushing for regulation, financial performance indicators and seek to deconstruct them. Similarly, calls for moral restraints and greater morality in business may lead to various institutional designs and strategies to build self-restraint in organisations and whilst certainly an important aspect of “regulating” corporate capitalism, such “moralism” fails to appreciate that “conduct” cannot be divorced from the wider context of social and economic power. The actual and potential costs of the credit crunch are already huge, but they must be seen as part and parcel of the rhythm of financialised capitalism. The solution to the huge problems outlined above is not to abandon money or finance but to embed them in a properly regulated system. When properly embedded in structures of social control, finance can help to allocate capital, facilitate investment and smooth demand. But if it is unaccountable and unregulated it becomes sovereign in the reallocation process, and can grab the lion’s share of the gains it makes possible, including anticipated 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 to information and power imbalances. Such distortions multiply as “financialisation” takes hold. It is boosted as the logic of finance becomes ubiquitous, feeding on a commodification of every aspect of life and the life-course – student loans, baby bonds, mortgages, home equity release, credit-card debt, health insurance, individualised pension funds (Martin, 2002). The issues canvassed here are clearly political issues and a return to the political is necessary if reforms are to be effective. Debates about corporations, the market, the state and their attendant effects need to be revisited. This would result in more regulation like the neoliberal governance response to Enron; its efficacy cannot be assumed and needs to be questioned and challenged (Soederberg, 2008). On a more mundane level, this requires greater elements of cooperation, collaboration and contestation of ideas within and across locales and countries. The financial crisis has brought forth a coalition of the unwilling with strange bedfellows and the task for critical scholars and practitioners is to ensure the process continues to influence the “new” centres of power that now claim to represent 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, senior executives were still awarded handsome pay-offs by their boards of directors. The CEOs of two Wall Street banks left their jobs in 2007 clutching lavish rewards for failure: $160 million for Stanley O’Neal at Merrill and $90 million for Charles Prince at Citigroup. At Bear Stearns the rescue left shareholders with $10 a share compared with $170 a year earlier. One-third of the bank’s shares were held by its employees, many of whom will also lose their jobs. Board members lost heavily on their holdings, but will remain very rich men since during the great CDO bonanza – in which their bank was a lead player – they had earned fees and bonuses of tens, or even hundreds, of millions. Morgan Stanley also announced a $9.4 billion loss in the last quarter of 2007 but still increased the size of its bonus pool by 18 per cent, arguing that the losses had been concentrated in structured finance and should not blight the rewards of those who continued to be profitable. Employee compensation generally runs at 50 per cent of an investment bank’s revenue. In 2007 this rose sharply and in some cases came close to 100 per cent (Rajan, 2008). 2. Thousands of mortgages would be consolidated into one instrument and the resulting pool of debt subdivided into ten tranches, each representing a claim on the income accruing to the underlying mortgages; the lowest tranche represented the first to default, the second the next poorest-paying assets and so on up to the senior levels which were least likely to default. The different tranches’ vulnerability to default was hedged by taking out insurance, at rates varying according to the perceived level of default risk. Note that a feature of the securitising and tranching process is that the holders of a tranche would not know which specific mortgages 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 which the basic industrial structure no longer needs to be built up from scratch but simply reproduced (and thus can be normally funded out of depreciation allowances); the absence for long periods of any new technology that generates epoch-making stimulation and transformation of the economy such as with the introduction of the automobile (even the widespread use of computers and the internet has not had the stimulating effect on the economy of earlier transformative technologies); growing inequality of income and wealth,

4.

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which limits consumption demand at the bottom of the economy, and tends to reduce investment as unused productive capacity builds up and as the wealthy speculate more with their funds instead of investing in the “real” economy – the goods and services producing sectors; and a process of monopolisation (oligopolisation), leading to an attenuation of price competition – usually considered to be the main force accounting for the flexibility and dynamism of the system. Although this behaviour of the banks goes far beyond all such activities, it is not unique. In a book published in 1974, called The Bankers, the author Martin Mayer criticised the banks for over-extending themselves. In April 2008, the International Monetary Fund (2008, p. 12) was estimating that total losses were likely to come to $945 billion: “Global banks are likely to shoulder roughly half of aggregate potential losses, totalling from $440 billion to $510 billion, with insurance companies, pension funds, money-market funds, hedge funds and other institutional investors accounting for the balance”. This is most evident in financial trading particularly through trading in foreign exchange markets and in derivatives. A New York Times (NYT) report noted that in 2006, the financial sector’s share of total corporate profits in the USA rose from 8 percent in 1950 to 31 percent in 2006 (New York Times, 11 December 2007) There are a number of studies linking financialisation, neoliberalism and dollar hegemony. See for example, Harvey (2005), Glyn (2006) and Phillips (2006, 2008). David Harvey (2005) sees this process as a process of accumulation by dispossession through which working people are divested of their rights and assets, for example, the privatization of water, health care and education, goods that had been or should be entitlements. The sale of these “goods” in private markets dispossessed those who could not afford what should have been theirs by right. At the global level, this has resulted in loss of government benefits, dispossessing people through debt repayment and the liberalisation of the local economy to benefit foreign investors and domestic elites. Ironically, as Martin Wolf (2006) has shown, the economy grew twice as fast in the golden age (circa 1945-1873) as in the succeeding era of globalisation. See also the more scholarly work of Maddison (2001). Beginning in January 2001, the Federal Reserve Board lowered interest rates in 12 successive rate cuts, reducing the key federal funds rate from 6 percent down to a post-Second World War low of 1 percent by June 2003. Low interest rates tempted many homeowners to go deeper 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 buoyant economy and consumption growth, but only at the cost of growing personal and corporate indebtedness. This expanded the number of mortgage borrowers despite the increasing prices of houses. Many of these mortgage loans amounted to 100 percent of the appraised value of the house and could only be sustainable as long as house prices continued to rise and rates remained low. Heavy borrowing is, as such, used to buy up financial assets, not based on the income streams they will generate but merely on the assumption of increasing prices for these assets. In a recent book, Fleckenstein and Sheehan (2008) have critically appraised Alan Greenspan’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 And Loan crisis; the collapse of Long Term Capital Management; the tech bubble of 2000 and the credit bubble and real estate crisis of 2007. Michael Moran, for example, has pointed out that there is a long history of popular protest and 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 repeatedly been “pacified” through the process of further “codification, institutionalisation and juridification” (Moran, 1991, p. 13). Furthermore, financial elites have been adept at responding to these pressures and able to use them to create regulatory frameworks beneficial to them. In October 1907, a hundred years before the onset of the current subprime crisis, the USA experienced an 11 percent decline in GDP and accelerating runs on it banks (Studenski and Krooss, 1965; Chernow, 1990). In the absence of a central bank, the US treasury and Wall Street relied on J.P. Morgan to organise the bailout. As Henry Paulson had done, Morgan let the giant Knickerbocker Trust go under in spite of its holding $50million of deposits for 17,000 depositors, fuelling further runs and panic. Finally, using $25 million provided by Treasury and a similar amount provided by Wall Street, Morgan then dispensed the liquidity to calm the markets (Chernow, 1990, pp. 123-5). This chain of events is not dissimilar to what is currently happening in the USA. Quantitative economists, however, continue to naively believe in a simple numerical discount rate which can be used to calculate the net present value of a future stream of income 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 once unpredictable and carries the past within it. Morgan Stanley compared the rate of downgrades in 2006-2007 to the historical norm for 1998- 2006. The results are stunning. Among AAA-rated subprime residential mortgage-backed securities, 4 per cent were downgraded (whereas the historical norm was 0.12 per cent). Among AA rated securities, 12.2 per cent were downgraded (versus an historical norm of 0.64 per cent). Of securities rated A and below, some 97 per cent experienced downgrades (versus the historical norm of 1.24 per cent). George Soros (2008) calls for “a clearing house or exchange with a sound capital structure and strict margin requirements to which all existing and future contracts would have to be submitted”.

References Augar, P. (2006), The Greed Merchants: How the Investment Banks Played the Free Market Game, Penguin, London. Augar, P. (2008), “Do not exaggerate investment banking’s death”, Financial Times, 22 September. Bennis, W. and O’Toole, J. (2005), “How business schools lost their way”, Harvard Business Review, Vol. 85 No. 5, pp. 96-104. Brenner, R. (2002), The Boom and the Bubble, Verso, London. Brenner, R. (2006), The Economics of Global Turbulence: The Advanced Capitalist Economies from 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 Wall Street 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. Cudd, M., King, J.O. and O’Hara, B. (Eds) (1995), “Assessment of the nature and status of the MBA restructuring trend”, Journal of Education for Business, Vol. 71 No. 4, pp. 44-8. Dapice, D. (2008), “Bad spell on Wall Street”, 24 January, available at: www. Policyinnovations.org

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 the Federal Reserve, Wiley, New York, NY. Foster, J.B. (2007), “The financialisation of capitalism”, Monthly Review, Vol. 58 No. 11, pp. 8-10. 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”, Management Learning, 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. 41 No. 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 Risks and Restoring Financial Soundness, International Monetary Fund, Washington, DC, available at: www.asiaing.com/global-financial-stability-report-2008.html (accessed 30 July 2008). 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 of popular 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 and Management 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 US experience”, Journal of Management Studies, Vol. 41 No. 8, pp. 1503-20. Phillips, K. (2006), American Theocracy, Viking, New York, NY. Phillips, K. (2008), Bad Money, Viking, New York, NY. Pink, D. (2004), “The MFA is the new MBA”, Harvard Business Review, February, pp. 21-2. Porter, L.W. and McKibbin, L.E. (1988), Management Education and Development: Drift or Thrust into the 21st Century?, McGraw-Hill, New York, NY. Rajan, R. (2008), “Bankers’ pay is deeply flawed”, Financial Times, 9 January. Roach, S. (2007), “America’s inflated asset prices must fall”, New York Times, 16 December. Roome, N. (2005), “Teaching sustainability in a global MBA”, Business Strategy and the Environment, Vol. 14, pp. 160-71. Rubin, R. (2003), In an Uncertain World: Tough Choices from Washington to Wall Street, Random House, New York, NY. Rude, C. (2004), “The role of financial discipline in imperial strategy”, in Panitch, L. and Leys, C. (Eds), Socialist Register 2005: The Empire Reloaded, Merlin Press, London. Scholtes, S., Chung, C. and Brewster, D. (2008), “JPMorgan swoops in again”, Financial Times, 26 September. Schwartz, N.D. and Creswell, J. (2008), “What created this monster?”, New York Times, 23 March. Shiller, R. (2008), The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do about It, Princeton University Press, Princeton, NJ. Sinclair, T. (2005), The New Masters of Capital, Cornell University Press, Ithaca, NY. Sloan, A. (2008), “On the brink of disaster”, Fortune, 14 April, p. 82. Soederberg, S. (2008), “A critique of the diagnosis and cure for ‘Enronitis’: the Sarbanes-Oxley Act and neoliberal governance of corporate America”, Critical Sociology, Vol. 34 No. 5, pp. 657-80. Soros, G. (2008), “The false belief at the heart of the financial turmoil”, Financial Times, 3 April. Stelzer, I. (2008), “Old ‘friends’ are happy to blame US for the chaos”, Sunday Times, 5 October. Studenski, P. and Krooss, H. (1965), Financial History of the United States, McGraw-Hill, New York, NY. Tett, G. (2007), “Volatility wrecks financial world’s value at risk models”, Financial Times, 12 October. Tett, G. and Davies, P. (2007), “Out of the shadows: how banking’s secret system broke down”, Financial Times, 17 December. Walker, D. (2008), “Washington must heed fiscal alarm bell”, Financial Times, 22 September. Weick, K. (2003), “Positive organising and organisational tragedy”, in Cameron, K.S., Dutton, J.E. and Quinn, R.E. (Eds), Positive Organisational Leadership, Berrett-Koehler, San Francisco, CA, pp. 66-80. Weisman, S.R. (2008), “Financial regulators suggest tighter controls”, New York Times, April 12. Wessel, D. (2008), “Ten days that changed capitalism: officials improvised to rescue markets; will it be enough?”, Wall Street Journal, 27 March. Wolf, M. (2006), Why Globalization Works, Yale University Press, New Haven, CT. Wolf, M. (2007), “Unfettered finance is fast reshaping the global economy”, Financial Times, Vol. 18, June.

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 Perfect Storm, Wiley, New York, NY. Bryan, D. and Rafferty, M. (2006), Capitalism with Derivatives: A Political Economy of Financial Derivatives, 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. 10 No. 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 corporate sector”, 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 author Loong Wong works at the University of Canberra, Australia. He has taught and researched at universities in Australia, Denmark, New Zealand and Malaysia. His research has focused on international business practices and he has published in the Journal of Contemporary Asia, Asian Business and Management, Chinese Management Studies, Prometheus, and Information Society amongst others. He is also active in a range of public interest and social movements. Loong Wong can be contacted at: [email protected]

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Department of Geography, University College London, London, UK Abstract Purpose – This article seeks to discuss three key issues raised by the recent financial crisis: the rise of “activist states”; a new focus on the geopolitical effects of finance; and possible future social implications of the rapid response to crisis. Design/methodology/approach – The paper provides an analytical overview of three of the implications 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 rapid rise of “activist states” as a result of impaired liquidity; the bringing to light of long-neglected geopolitical spaces of finance; and the opportunities for improved social aims communication and lobbying 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 article introduces the idea of a financial “activist state” as a public entity which behaves like an activist shareholder in the market. The article also suggests that the political and banking reaction to the current crisis can be seen in terms of opportunities to improve communication of social, political and policy aims in the future. Keywords Recession, Financial markets, Credit, International business, Communication Paper type Viewpoint

Introduction: activist states, new fractures, and (missed) opportunities The current financial crisis is far from over. Shocks take years to work through the financial system, and it is hard to assess their far-reaching consequences before distance 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 at this time. Rather, the aim here is to highlight some potentially new features at the interface between finance and politics, and to suggest some ways in which financial professionals, and the political reaction to the current crisis, can be seen in terms of opportunities 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 increasingly high-pitched voices of the banking and political world in calling for hundreds of billions of dollars to be poured into the financial system in the form of “bail-outs”, loans, and credit. critical perspectives on international business Vol. 5 No. 1/2, 2009 pp. 78-84 q Emerald Group Publishing Limited 1742-2043 DOI 10.1108/17422040910938695

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

voted down by political representatives concerned with constituency reactions (Weir et al., 1988). The sense of crisis, in other words, has legitimised demands on taxpayers. These demands dwarf previous requests, by less powerful actors and social groups, focused on a variety of social and policy issues. This commentary argues that a critical analysis of the mechanisms through which various actors (lobbyists, policy institutions, politicians, and players in the financial industry themselves) readily and powerfully coalesced around an emergent discourse of financial crisis could lead to a progressive and constructive understanding of mechanisms needed to mobilise resources and capital 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 markets should cause business leaders and scholars alike to rethink the way in which the state is conceived vis a` vis markets generally, and private firms specifically. This is due to the wider repercussions of the financial crisis in other industrial sectors, as well as in political life, and the action which governments have taken to mitigate these effects. It is precisely these reactions that signal a re-engagement of the state with the market, in a readjustment (or, as some would argue, stabilisation) of neoliberal forms of governance (Bakker, 2005). The dust raised from the current crisis has not settled. It is therefore hard to provide a comprehensive description, in this short space, of the various ways in which the state is engaging in deeper ways with financial markets. However, it has become apparent that states are, indeed, proactively and rapidly changing the ways in which they interact with financial firms. The recent crisis has seen national governments take increasingly large stakes in private companies. The motivation has been one of preserving these firms from potential failure, and stabilising the domestic financial market as a reaction to wider shocks stemming from problems with liquidity and credit markets. For example, at the time of writing, the British government was close to effectively nationalizing Bradford & Bingley, Royal Bank of Scotland and HBOS, a large 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 as activist shareholders in financial firms. The notion of “activist states” has already been applied to states heavily involved in delivering social and health policies (Ramesh and Holliday, 2001; Biehl, 2001). This article extends the concept of the “activist state” to signify those states which, through large stakes in financial firms, act increasingly like activist investors. This could be seen as a logical consequence of the fact that the financial industry is enmeshed with the rest of the economy, and, pari passu, with other industries and the diverse communities of citizens which make up the modern notion of a state. Finance – as the credit crunch has painfully brought home to millions of mortgage holders, savers and the energy poor – is deeply embedded in contemporary, everyday material life. At the same time, the economic landscape in question is not top-down: everyday material life interacts with, and influences, the financial industry. It comes as no great surprise that states are taking increasingly prominent stakes in financial firms, and that some of these firms – Goldman Sachs and Morgan Stanley being 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 with Spain’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 doing so rapidly and decisively – if decisiveness is the right word in an economic climate in which a week’s delay on the proposed $700bn bail-out of US banks in early October caused the Dow Jones to lose a record amount (800 points) in a single day. As Jose´ Vin˜als, Deputy Director of the Banco de Espan˜a, stated in a recent panel given to the IESE and Harvard Business Schools: [T]he global banking system is continuously evolving within what is known as the “new global financial landscape”. This is characterised by several features: free international capital flows, global financial markets and global banks, faster transmission of risks from one area to another, and potential cross border contagion effects. In this context, some new products of increasing complexity, many of them derivatives, are being introduced. We are also 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 (Vin˜als, 2008, pp. 4-5).

A new player in this evolving landscape is the activist state. Just as activist shareholders act to shape a company’s direction, aims and board, so the activist state aims to shape the direction of precisely those institutions – such as financial firms – which are crucial to national economies. Again, states have been taking stakes in national and international firms for a long time, through state-owned investment vehicles which often behave like private equity firms – witness Temasek Holdings of Singapore, the Abu Dhabi Investment Authority, or the China Investment Corporation in the People’s Republic of China. Furthermore, institutional investors retain major holdings in financial firms (Gillan and Starks, 2003). However, it is again a question of multiple large-scale investment decisions being taken over a short period of time: at the end of October 2008, North American and European governments are much more deeply and directly involved in financial firms than they had been just two months earlier. They have become activist investors. As this piece goes to press, surprise is being expressed on all fronts at the fact that governments are communicating views about firm development and direction following the purchase of large stakes in these firms. This should not be shocking, least of all to the business community: it is noteworthy, but not surprising, that states, having built positions which empower them to become activists, subsequently and increasingly act like activist shareholders. Geopolitical spatialities of finance The crisis has also rippled over the margins of the financial world and has impacted on national and international political power structures. For example, it has caused some unlikely alliances to appear and quickly dissolve. In the European Union, the governments of The Netherlands, Belgium and Luxembourg banded together in late September 2008 to inject $16.4bn into Fortis, a bank with cross-border operations in the same countries. Within three weeks of this move, however, these governments had moved to dismember Fortis, with the Dutch government nationalizing Fortis’s Dutch branch network (formerly ABN-AMRO), and the Belgian government planning to sell

Fortis’s Belgian operations to investment bank BNP Paribas of France (Schwartz and Dougherty, 2008). Governments have also become involved – through their new roles as activist shareholders – in the trading of divisions of individual financial firms. For example, non-toxic parts of part-nationalised businesses are being traded by European governments, as is the case in the selling of Bradford & Bingley’s UK retail branch network to Santander, a Spanish financial firm (Slater and Croft, 2008). Finance has always been intimately tied in to politics and political power. The recent crisis, the rise of activist states, and government involvement in taking over financial firms could, however, signal a shifting away from the dominant paradigm which has existed for the past 20 years. Since the early 1980s, there has been a decoupling, for want of a better expression, between the financial services industry and politics. Deregulation and privatisation (the hallmarks of a wider, neoliberal trend) became dominant economic paradigms. However, the crisis which started in 2007 has brought back to light those sunken links which unite political power with finance. The part-nationalisation of Icelandic banks in October 2008 – with the resultant potential loss of non-domestic savers’ deposits in those same banks – was not a state action with simple regional consequences. Rather, the regional crisis was followed by wider geopolitical ripples. Thus, at the regional scale, Britain and Iceland clashed diplomatically, with tense negotiations undertaken through their respective treasuries; the situation was closely followed in both countries’ media. Furthermore, Iceland’s deposit guarantee scheme called on reciprocal guarantee arrangements with other Nordic countries in order to guarantee domestic deposits. However, the guarantee was not extended to foreign (mainly British) depositors in newly globalised Icelandic banks. At a supra-regional geopolitical scale, the Icelandic government saw itself in the unprecedented position of having to petition to obtain a $4bn loan from Russia in the first week of October. This brief example shows how the financial landscape, and markets themselves, are increasingly losing their status as spheres of economic action supposedly separate from geopolitical upheavals. The financial crisis has therefore highlighted a whole set of relations and links between finance and domestic and international politics. These links and feedback loops have to be taken into account from now on when considering the financial and socio-political landscape of the post-crisis system: the world is clearly no 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 to which lack of liquidity and reduced market demand will determine the slide into recession of several countries and regions of the globe. The regulatory landscape which will emerge out of the crisis is still the subject of active debate, as is the efficiency of current risk management regimes within financial firms. Other, minor issues will also need to be resolved, such as unlikely moves to cap executive pay, or introduce more oversight within organisations. The reaction of certain firm typologies to the crisis is also evolving at the time of writing, and how these firms weather this period of instability, 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 hedge funds and private equity firms. Within the absolute returns industry, risk arbitrage and “black box” hedge funds, as well as value funds, will be affected by lack of liquidity, potential draw-downs, and current short-term regulations against short-selling (admittedly, this last factor will not apply to many value-oriented hedge funds). Within private equity, the collapse in the availability of cheap credit and the risk exposure engendered by large amounts of leverage in the current climate put business models focused on short-term buyouts at risk. Future scenarios notwithstanding, a key consequence of the crisis has been the ability of governments to rapidly mobilise unprecedented amounts of capital in an effort to restore liquidity and market confidence. Plans by the US Treasury to inject $700bn into “bail-out” plans were quickly followed by European governments’ similar injections of capital (albeit in smaller individual amounts) into the system at the national scale. What is striking and new here is, first of all, speed. Response times have been measured in weeks rather than months or years. In the USA, the use of state funds was agreed to within three weeks. In the UK, the timeline was faster, and moves on the island were quickly echoed by similar interventions (or intentions to intervene) elsewhere. This commentary will leave it to others to argue whether this represents a scaling back of neoliberal tendencies towards minimal state involvement in industry. Rather, what is interesting is the speed with which a response to financial crisis was engineered and put into place. Whether or not the planned bail-outs work, the reality is that 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 both public opinion and political will were both intense and highly goal-oriented. Furthermore, this intense pressure – partly based on existing links and networks between 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 of domestic as well as international importance, coupled with the financial industry’s pressures on the political sphere, is indicative of missed opportunities for the resolution of social and other problems. Some of the key factors which led US and European politicians to make public funds available for the rescue of industry are the rapid construction of a sense of burgeoning crisis, coupled with the fact that calls for the use of public funds were both naturalised and prescriptive. Firms’ communications assumed that bail-outs were the only rational responses possible, and therefore it was natural – according to this line of argument – that governments would make public funds available. The financial industry’s claims to citizens’ fiscal contributions were therefore legitimised. This is not the case with other, more long-standing domestic and international social, political and medical issues – problems which are indeed continuing crises, but which do not affect transnational capital and therefore have little or no hold on the media, or on bureaucrats and politicians working on government budgets 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 of micro-enterprises in the developing world. Issues such as public health funding in

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 the most efficient ways to improve public health services or provide solutions to other social issues (reforms and efficiencies must also play their part), providing liquidity to ameliorate less-than-visible social crises would be a great step forward. However, the aim of this commentary is not to lament missed opportunities, but to highlight potential ways forward. First, the quick and decisive response to the crisis should be used by business leaders and by those involved in socio-economic advocacy and policy. Studying what has worked in this crisis, in terms of communication between industry and government, would help in the targeting of lines of communication with more social aims. Secondly, analysing the strategies which brought the crisis to the forefront of public opinion, and which naturalised the claims of financial firms to state funds, could lead to more effective social campaigning for non-state actors, NGOs, and policymakers scrabbling for funds which politicians often describe as meagre and unavailable – but which, clearly, are not. The crisis has, therefore, provided clear opportunities 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 England and 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”, Social Text, Vol. 22 No. 3, pp. 105-32. Brett, A.S. (2007), “Two-tiered health care: a problematic double standard”, Archives of Internal Medicine, Vol. 167 No. 5, pp. 430-2. Friedman, T.L. (2006), The World 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 of instiutional 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 on branch network”, Market Watch, 29 September, available at: www.marketwatch.com/ news/story/bradford–bingley-nationalized-uk/story.aspx?guid ¼ {FF8C6FD0EE03-4E97-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: activist state provision in Hong Kong, Malaysia and Singapore”, Journal of Social Policy, Vol. 30 No. 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/idUSTRE 48Q1Z520080929 (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 by government”, Bloomberg, 12 October, available at: www.bloomberg.com/apps/ news?pid ¼ 20601102&sid ¼ aw6Y9TU3RioI&refer ¼ uk (accessed 12 October 2008). Vin˜als, J. (2008), “The role of the Banco de Espan˜a in Spanish banking”, panel presentation at IESE 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”, in Weir, M., Orloff, A.S. and Skocpol, T. (Eds), The Politics of Social Policy in the United States, Princeton University Press, Princeton, NJ, pp. 3-27. About the author Federico Caprotti is a faculty member at the Department of Geography, UCL. His current research focuses on environmental discourse and factors which influence decision making in funding deals in the cleantech sector, with a particular interest in wind power deals in China, the USA and the UK. He has previously worked for Oxford University and the University of Leicester. Federico Caprotti can be contacted at: [email protected]

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The Kindleberger-Aliber-Minsky paradigm and the global subprime mortgage meltdown William V. Rapp

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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 US subprime mortgage market through the lens of the Kindleberger-Aliber-Minsky (KAM) paradigm as set forth in Kindleberger and Aliber’s Manias, Panics and Crashes, to first examine the bubble’s origins in the displacement caused by the internet collapse, the subsequent US recession, and the aggressive lowering of US interest rates. It shows how these events, combined with other technological and regulatory factors, resulted in a US housing bubble fueled by the aggressive securitization of mortgages by many large financial institutions, a reduction in their credit standards, and a lack of regulatory oversight. In this way it assesses the prime players in the process in terms of motivation and performance. Design/methodology/approach – The paper explores how the process peaked and began to unravel as cash flows at the base of the financial pyramid built through securitization slowed. Once the supporting cash flow came under pressure and was questioned, several major players went bankrupt or 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 combined to substantially reduce credit quality and increase leverage, vastly expanding the likelihood of a liquidity 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, for example, the Japanese real estate and stock market collapse or the US internet boom and bust. The analysis also shows how market reactions have been in line with what might be expected under the KAM paradigm. It also conforms with what Robert Shiller and Edward Gramlich anticipated and with normal bank behavior in a credit crisis. Originality/value – The paper assesses the policy responses to the crisis and their likely success under a KAM paradigm analysis. The proposed remedies already include the aggressive fiscal and lender 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 surprisingly there has been growing recourse to the courts seeking criminal and civil remedies. Also typical of such a dramatic boom and bust, governments are examining regulatory and legislative actions to address the current difficult economic and credit situation and to make sure that similar things do not occur in the 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 or proposed and what is or is not likely to work? Keywords Economic booms, Recession, Financial markets, Mortgage default, United States of America Paper type Viewpoint

Introduction This paper argues that the bubble paradigm explained in Manias, Panics and Crashes (Kindleberger and Aliber, 2005) applies to all aspects of the subprime mortgage crisis from 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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about the housing bubble, its inherent risks and the likely wide scope and disastrous financial and economic impact of a collapse. Indeed, if used by policymakers to raise cautionary flags it could have served theirs and the public’s long-term interests. Further as the KAM paradigm predicts, the subprime mortgage meltdown and its aftermath have brought numerous civil and criminal actions. For example, mortgage fraud in the USA, including Federal and state prosecution, is growing dramatically. Suspicious activity reports related to mortgage fraud increased over 1,000 percent between 1997 and 2005, and pending FBI mortgage fraud investigations rose from 436 in fiscal 2002 to 1,210 in fiscal 2007 (Grant, 2008). The huge increases in the US mortgage market and its increasing complexity have opened many attractive opportunities for fraudsters across a range of financial activities and institutions. The most common frauds involve “property flipping” or other schemes to get proceeds from mortgages or property sales via misleading appraisals or false documentation. The SEC is also looking at insider trading related to unexpected write-downs by publicly traded companies with assets tied to mortgage-backed securities. Further, plaintiffs’ lawyers and their clients have been active in making other claims such as misrepresentation or failure to disclose materials information, trying to recover some of the billions of dollars in losses. However, to grasp the subprime bubble and meltdown in its development, subsequent crash and current aftershocks, one must first understand the key changes that occurred in the financial markets for mortgage-related securities and their legal underpinnings along with how changes in US banking and security laws have complicated the situation. Structure and evolution of the US mortgage market The US residential mortgage market is a multi-trillion dollar market that has increased dramatically over the last five years. In June 2007 residential and non-profit mortgages outstanding 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 market has proliferated. Traditionally, up until about 25 years ago home loans and mortgages were usually arranged between a local bank or local savings and loan (S&L) and a local borrower with the bank or S&L holding the mortgage subject to local real estate laws and land registry regulations until maturity or the home was sold or the mortgage refinanced. But starting in the 1980s and expanding into the 1990s and the first years of this century, that all changed. Banks and S&Ls discovered the benefits of securitization and balance sheet turnover. They realized mortgages and other regular payment credit instruments such as auto loans and credit cards had steady cash flows that, if bundled, would provide investors with a steady income stream that could be capitalized 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 which they deducted fees. This innovation meant banks or S&Ls could rapidly turn over their balance sheets, since they did not have to wait until a loan was repaid or their capital increased to make new loans and expand revenues from loan servicing and origination fees. This process increased return on capital, earnings per share, and shareholder value, benefiting shareholders and corporate officers with stock options. In the 1980s, under the Basle agreements and Resolution Trust Corporation Act, banks and S&Ls

were subject to more stringent capital requirements relative to loans they booked. This gave them an incentive to no longer hold loans to maturity or payoff. Rather, as just explained, it made sense to package and sell them to long-term investors such as insurance companies (Rapp, 2004). As the new system evolved and became national or even international rather than local, other financial intermediaries emerged that specialized in specific functions within the overall mortgage packaging and sale to investors’ business chain. For example, mortgage brokers realized they could sell a New York mortgage to a Washington S&L that might price it more aggressively on rate and term than a local bank. This could be due to the other lender’s lower funding costs, desire to diversify risk across more markets, or interest in expanding its servicing portfolio to achieve economies of scale. Indeed, it could be a combination of these factors. Brokers could thus find borrowers the best rate within a competitive and integrated national market for residential mortgages that ultimately squeezed out the small local bank or S&L, a major reason why they have been less affected by the credit crisis. Further, as the market expanded, economies of scale in specialization at different points in the mortgage financing and investment chain emerged. The development of the internet and computer power only increased such considerations as technological progress created significant cost improvements in sourcing and processing mortgage applications and approvals online. Just as a homebuyer could now virtually tour several houses in an afternoon without leaving home, they could compare mortgage rates from several sources, while lenders could quickly scan a buyer’s credit score. Similarly huge increases in computing power and telecommunications introduced economies of scale in servicing the mortgages (Rapp, 2004) and the investors. Under this new and evolving structure it was quite possible no federally insured bank or S&L was involved in the loan or any one investor would hold the actual mortgage as security. A mortgage broker could find a lender such as GMAC or GE Credit Services or Merrill Lynch instead of a traditional bank or S&L. These lenders would bundle the mortgages into pools, usually as a trust, and either themselves or via investment banks such as Lehman Brothers or Bear Stearns place them with investors (Yamada and Kubo, 2008). But rather than selling the pools or percentages of the pool to an insurance company, hedge fund, or structured investment vehicle (SIV), they sold pieces of the pool’s cash flow tailored to an investor’s requirements. Thus, long-term investors might only want the final monthly payments while another, shorter-term investor, might desire only the first three years’ interest. The longer dated monthly payments would then be sold to a different investor group. Thus no investor owned an entire mortgage and none were involved in the loan administration or handling of the security. In “House of junk”, Fortune details a Goldman Sachs deal that highlights these considerations (Sloan, 2007). Large computer systems supported the servicing of these different structures and favored firms that could source and service in volume, spreading the system costs over a large number of mortgages, customers and structured investments. This led to a factory mentality in creating the pools, including the supporting legal documentation, a practice that has carried over to foreclosure activity in the current economic downturn and housing crisis (Morgenson and Glater, 2008). Because the initial lenders only expected 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, several specialized mortgage lenders used this technique, including those focused heavily on the subprime mortgage market. In their 2005 annual reports GM and GE indicate this kind of activity, and indeed GM indicated $4 billion in mortgage servicing rights on its balance sheet. The Countrywide Financial Corporation (CFC), perhaps the largest mortgage lender in the USA, did this extensively with its commercial paper backed by its mortgages (Countrywide Financial Corporation, 2007). It did this even though a subsidiary was a federally insured S&L. It continued this funding practice up until 2006, probably to avoid the more stringent capital requirements the government had imposed on S&Ls in 1989 as part of The Resolution Corporation Trust Act[1]. The collapse 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 Loan Holding Company (Countrywide Financial Corporation, 2007). Nevertheless, the size of the mortgage financing market, its rapid growth and its increasing complexity have combined with the current meltdown and the billions in losses by financial institutions and investors, to create – as the KAM paradigm would expect – many opportunities for legal actions, including criminal prosecutions for fraud and numerous civil actions seeking a legal remedy and some restitution of the lost billions (Hamilton, 2008). Not surprisingly, the points of legal altercation are generally at the intersections that represent handoffs of the loans and mortgages between institutions such as the mortgage broker to the lender or between the lender and the packager or the packager and an investor since these points have usually been accompanied by contractual documentation representing the warranties and responsibilities of the party doing the handing off of the offering to the one receiving or accepting the securities. These contractual obligations then become the basis for any recovery. However, the cookie-cutter approach used to produce the securities on a mass production basis are now creating problems. This is because the slicing of loan pools into several pieces with varying rights to specific mortgage payments, 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 who controls the pool or the underlying mortgage loan and its payment stream. Indeed, in several cases the servicing agent holds the mortgage in trust for the pool, while the pool is controlled by the super senior tranche for a diverse group of investors with conflicting interests. Kindleberger-Aliber-Minsky paradigm This scenario’s boom and bust tracks the KAM paradigm perfectly. So predicting the bust and it consequences was not as difficult as Robert Rubin has posed. Indeed, in his book Subprime Mortgages, Edward Gramlich (2007) did exactly that. The KAM paradigm explains that every mania or bubble begins with some large displacement that changes expectations, such as a major technical advance like the commercialization of the internet, or rapid deregulation such as occurred in Japan in the early 1980s or in the USA in 1999 with the repeal of Glass-Steagall under Gramm-Leach-Bliley, or a large injection of liquidity such as occurred after the internet bust. 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 the elimination of Glass-Steagall vastly increased the number of players while the internet

boom had created tremendous and low-cost computing and communications power that, as described above, greatly facilitated and accelerated the credit expansion. Once the displacement has occurred related assets start to appreciate. This leads to the interaction of greed, speculation and further asset appreciation, or a bubble that continues to expand until the leverage fueling the system can no longer support further expansion 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 and accelerates the collapse on the downside as banks become more conservative relative to risk and begin to restrict credit. Here the banks’ over-lending to support the acquisition and holding of mortgage-backed securities occurred directly to investors, indirectly via lending by hedge funds the banks funded, and also through various derivatives such as 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 1929 with respect to stocks. Applying KAM KAM paradigm and subprime mortgage meltdown – dislocation and bubble This happened in the US mortgage market as housing prices rose faster than people’s incomes. 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, foreclosures began to rise and new homebuyers were priced out of the market. These developments caused 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 the value of their investments and the stage was set for a KAM panic as heavily leveraged investors tried to convert to cash. The flood of assets coming to market combined with decreased demand due to risk reassessment and decreased credit availability brought the inevitable crash. No surprises here. Crash; scandals and scams; political and legislative actions The crisis following the crash and the pattern of its aftermath also tracks KAM perfectly. As Kindleberger notes, historically almost every financial boom and bust is followed by a series of scandals (Kindleberger and Aliber, 2005). Since people are usually hurt by the collapse in asset values and especially those involving fraud, there is usually political pressure to punish those perceived as having caused the problem as well as to prevent future abuses even though the real reason for the boom is generally the public’s greed, in this case using the equity in their homes like an ATM to fund consumption. Still, the panic that follows the collapse as the bubble runs out of liquidity to further support much less inflate asset prices frequently spurs “barn-door closing” legislation. The Federal Reserve, the SEC and Sarbanes-Oxley resulted from the financial crises of 1905, the crash of 1929 and the collapse of the internet bubble respectively. It is thus not surprising the US housing market bubble and its collapse, particularly in the subprime mortgage market that was especially subject to broker and lender abuse, has exposed similar bad practices such as predatory lending and no verification mortgages. 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 these issues. Yet interestingly the new legislation just builds on the intent of Congress in its 1989 legislation, stimulated by the prior LBO bubble collapse and S&L crisis, regarding loans secured by real estate needing to meet “standards as are consistent with safe and sound business practices”[1]. Thus Congress’s response in 1989 and 1990 to the S&L crisis and the junk bond scandals, when by enacting FIRREA it substantially increased and broadened penalties for crimes impacting financial institutions 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 the bubble 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 already many have been filed: the City of Springfield and the Massachusetts Attorney General have sued Merrill for misrepresenting the quality of subprime CDO investments and associated risks. The City of Cleveland is suing 21 Ohio banks under Ohio’s Public Nuisance Law, accusing them of reckless lending that is placing a financial and administrative burden on the City due to the high number of foreclosures (Hamilton, 2008). Reflecting the international scope of the bubble and its collapse, the Australian Shire Council of Wingecarribee near Sydney is suing Lehman Brothers, arguing that Lehman improperly sold them risky mortgages. According to the Financial Times, the town claims Lehman had “failed to act in the council’s best interest and engaged in misleading and deceptive conduct while serving as its financial adviser and investment manager by promoting the Lehman-originated Federation CDO, which was exposed to the US subprime market. Federation was last month marked down to 16 cents in the dollar”. The town’s representative claims “it relied on Lehman’s advice and representations in making its investments”. (Fry, 2007). Meanwhile Lehman is suing Fieldstone Investment Corporation for having sold them “dubious” loans. Lehman claims borrowers’ income and the appraised home values were overstated and the conditions of the homes were poor. Their requested remedy, which Fieldstone is resisting, is to buy back the problem loans. Similarly PMI Group, a mortgage insurer, is suing subprime lender WMC in California to buy back loans PMI insured, claiming the latter “systematically” did not apply “sound underwriting practices” and made the loans fraudulently or “in violation of the standards 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 pool and 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 against some officers and directors claiming they turned a blind eye to deviations from mortgage underwriting standards. As part of their case, the “plaintiffs contend that the officers and directors dumped shares even as the company spent $2.4 billion to repurchase 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 program several times, each time increasing the shares to be sold, something the SEC regulations do not allow (Morgenson, 2008).

Investors in two hedge funds organized in the Cayman Islands that were feeder funds for a Bear Stearns master fund have successfully seized control of the feeder funds in a Cayman court by having their own liquidator appointed. The court saw the master fund liquidator as having a conflict. The investors hope control of the feeder funds will give them standing to sue. The investors argued “that [Bear] generated and relied upon erroneous net asset value calculations and that [Bear] ‘warehoused’ or ‘dumped’ unrealizable [. . .] subprime debt in the feeder funds in contravention of the offering memorandum”. Further, the judge ruled that Bear should share some of the costs as “the bank was behind the decision to put the funds into liquidation ahead of a petition 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 obligations regarding $3.1 billion in credit default swaps (CDS). Merrill said, “We filed suit to make clear that XL Capital Insurance Inc. is required to meets its contractual obligations for credit default swaps it agreed to” (Charles Schwab, 2008). Barclays Bank believes itself to be the victim of a hedge fund managed by Bear Stearns that irresponsibly invested investors’ money in complex subprime securities (Larsen and Murphy, 2007). HSH Nordbank, a state-controlled German bank, is suing UBS in US Federal court under New York law. It contends UBS improperly sold it complex collateralized debt obligations (CDOs) that it mismanaged. HSH asserts its claims based on “the manner in which the investments were sold to HSH Nordbank and UBS’s subsequent management of the assets [being] clearly contrary to [its] interests”. HSH claims UBS was supposed to manage the investment conservatively and prudently, but did not (Werdigier, 2008). Under ERISA, managers of pension funds have a fiduciary responsibility to act in the interests of their clients. Under a pending case, State Street Global Advisors, a subsidiary of State Street bank, has set aside $618 million to “settle claims that the firm invested in risky mortgage-related securities”, including those brought by five pension plans. The pension clients claim State Street told them the funds “would be invested in risk-free debt securities (e.g. Treasuries) but were used instead to acquire ‘high risk’ investments and mortgage-backed securities”. ERISA requires “a prudent man standard of care”. It appears State Street now recognizes that CDOs backed by subprime mortgages do not meet this test. Many mortgage lenders and underwriters have been accused of taking inadequate reserves or not properly accounting for returned mortgages pools or those held in portfolio even while delinquencies and foreclosures were rising. In one class action, Michael Atlas v. Accredited Home Lenders Holding Co. (WestLaw 80949, 2008), the plaintiffs allege Accredited and certain directors concealed the firm’s “true financial condition and made materially false and misleading statements regarding the company’s operations and income”. Particularly, they cite the firm’s assertions underwriting standards for subprime borrowers were especially conservative and reserve policies for possible delinquent loans or repurchase obligations were more than adequate. Further, the plaintiffs allege Accredited did not write down to fair value properties gained by foreclosure. Since, given these considerations, Accredited’s financial statements seem to have erroneously and artificially inflated income, the plaintiffs assert they have a course of action. The Federal Court in Southern California agreed 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 the deadline for filing its form 10-K, and the new auditor requiring the company to restate to increase its allowance for loan losses by over $30 million”. Evaluating policy solutions and concluding recommendations The above analysis indicates the subprime mortgage crisis and its aftermath have in all respects followed the KAM paradigm. The bubble’s development and its causes were recognizable as early as 2005 (Shiller, 2005; Gramlich, 2007). It was then that the Fed should have used its regulatory and bank examiner powers to impose stricter bank credit standards and greater capital allocations against such lending. If they had, the final mania might have been avoided and the collapse and its aftermath significantly moderated. However, because this was not done, we now have a financial crisis of global 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? Recent lender of last resort actions the Fed and other central banks have taken to assure market 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 has seriously affected world credit markets, including inter-bank lending. This is a direct result of the deregulation and globalization of financial markets during the 1990s and the early part of the twenty-first century. Further Glass-Steagall’s repeal meant investment banks particularly became major players in packaging and distributing these products globally, along with related instruments such as credit default swaps that magnified the risks of any downturn. Therefore in the medium term the Fed and other regulatory bodies need to examine ways to increase the transparency and decrease the leverage inherent in these financial products and the institutions that create and distribute them, insisting on a greater appreciation and valuation of the related risks, especially if the investment banks want and need greater access to central bank credit. In addition, Congress and the Administration need to take measures to reduce the over-supply of housing and the possible cascading downward spiral of foreclosures and falling home prices that are seriously affecting the real economy including rising unemployment and a possible recession. Fiscal and monetary policy alone will not do the trick. There is also a longer-term policy requirement. Over-confidence in laissez-faire market-based solutions has already resulted in two large asset bubbles with adverse economic consequences. Therefore, as already initiated by the Fed and the US Treasury, there is a need to assess and develop regulations and policy responses to unwarranted asset inflation. The KAM paradigm is a useful place to begin this assessment, both in terms of identifying when a rapid rise in asset prices is indeed a bubble and in developing the appropriate responses for which transparency and micro regulatory actions may be more appropriate moderating actions to growing system risks than macro monetary and fiscal policies. Note 1. Financial Institutions Reform, Recovery, And Enforcement Act Of 1989, P.L. 101-73 or FIRREA, pp. 3-4.

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 Financial Corporation, 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 Angeles Times, 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 author William V. Rapp is the Henry J. Leir Professor of International Business at the New Jersey Institute of Technology’s School of Management. William Rapp can be contacted at: rappw@ adm.njit.edu

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Wrong assumptions in the financial crisis Manuel B. Aalbers

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Amsterdam 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 current financial crisis are wrong because they misunderstand what takes place in the mortgage market. Design/methodology/approach – The paper discusses four wrong assumptions: one related to regulation, one to leveraging, one to subprime lending and one to predatory lending. It briefly discusses some policy implications. Findings – The role of the state in the mortgage market is more complex than suggested by those who 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 subprime loans were sold to prime borrowers. Subprime lending was not designed to increase homeownership rates, but to fuel profits by exploiting vulnerable borrowers. Practical implications – It is too easy to argue that everyone made mistakes; most borrowers cannot be blamed for being sold risky, overpriced loans. A rescue plan is needed for defaulting borrowers and those already in foreclosure. Originality/value – The paper does not present new research, but brings together research that demonstrates that the roots of the crisis in the mortgage market are in many ways different from what is suggested by professionals and journalists alike. Keywords Recession, Credit, Mortgage default, Loans, Regulation, United States of America Paper type Viewpoint

critical perspectives on international business Vol. 5 No. 1/2, 2009 pp. 94-97 q Emerald Group Publishing Limited 1742-2043 DOI 10.1108/17422040910938712

The current financial crises is presented as one in which homeowners took out risky loans that were pushed by greedy loan brokers and lenders who didn’t care about the riskiness of these loans as they would be packaged and sold off as residential mortgage-backed securities (RMBS) anyway. It continues to present a network of agents that have not paid enough attention to risk: not only borrowers and lenders, but also the state, regulators, investors and rating agencies. This image of the roots of the financial crisis is not wrong, but it is limited in explaining what went wrong. In this short contribution I will discuss four wrong assumptions in discussions on the roots of the financial crisis in the mortgage market. First, it is too easy to argue that the state and regulators were not acting. The state has enabled both securitization and subprime lending (Aalbers, 2008; Immergluck, 2009). Gotham (2006) has studied the deregulation of the mortgage market and demonstrates how the federal government, step-by-step, has enabled securitization, for example 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 have done too little, because they either were heavily understaffed or assumed financial markets 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

banking regulations and could operate within an almost non-existent framework. On the other hand, several American states such as North Carolina and West Virginia introduced additional state regulation. In 2003, four years before the crisis, New Mexico even introduced a Home Loan Protection Act. Yet, many state initiatives were blocked by the federal government and states were forced to withdraw certain acts and regulations. Something similar happened on a lower level. In Ohio, the City of Cleveland, which includes the zip code with the highest number of foreclosures in the country 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, but got into trouble with Ohio State as the latter argued that it was not the City’s responsibility to come up with financial regulation. In other words, we cannot say that the state did not do anything: while some state institutions enabled securitization and subprime lending by implementing “facilitating laws” and by ignoring their regulatory responsibilities, other state institutions tried, often unsuccessfully, to combat the negative aspects of the new financial regime. Second, the idea that “everyone is guilty” does not really explain why losses in the financial markets run into hundreds of billions and perhaps even one to two trillion US dollars worldwide. How could a national house price decline of 20 per cent cause such big losses for investors involved in RMBS? The short answer is leveraging. Because many investors, such as investment banks, bought RMBS with borrowed money, both the profits and the losses would be disproportionately large. A leverage factor of 14 was average; factors of 20 or 30 were not uncommon. For example, if an investment bank is able to borrow money for 6 per cent and expects a return of 8 per cent on low-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 the interest rate for which they have borrowed money, for example, respectively, 4 per cent and 2 per cent, the investment banks not only miss 4 per cent or 14 per cent calculated profit, they also have to take their losses on their equity. For example: 14 (the average leverage factor) times, respectively, 2 per cent (6 per cent minus 4 per cent) and 4 per cent (6 per cent minus 2 per cent) equals equity losses of, respectively, 28 per cent and 56 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, and especially subprime RMBS, effectively went bankrupt. Third, both professionals and academic economists do not pass up an opportunity to 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 even though they had bad credit. A majority of the subprime loans went to borrowers with prime credit (Brooks and Simon, 2007; Dymski, 2007). In other words, subprime lending should not be defined as lending to borrowers with poor credit, but as lending at higher fees and interest rates whether or not borrowers actually have bad credit. In 2006, 13 per cent of outstanding loans were subprime, but 60 per cent of the loans in foreclosure were subprime, up from 30 per cent in 2003 (Nassar, 2007). Selling subprime loans to prime borrowers was good business for both mortgage lenders and brokers. Lenders could charge higher interest rates on subprime loans and thus make more money. For this reason lenders gave brokers bigger sales fees for selling subprime loans. Brokers did not have negative results as a consequence of defaulting borrowers, 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 more money on clients by selling them another loan. Fourth, it is often argued that subprime lending enabled many people that were formerly excluded from homeownership, i.e. low-income and ethnic minority groups, to buy a house and enjoy the benefits of homeownership. This is questionable for at least two reasons. Firstly, many of these borrowers had bought properties at the lower end of the market that needed improvement work and because of the high interest rates their monthly expenses often went out of scale with their income. Homeownership for many subprime homebuyers became a burden rather than a joy. Second, most subprime loans were not enabling home ownership as more than half of them were refinance loans and second mortgages – in other words, loans for people who already owned a mortgaged property. Most of the refinance loans were designed in such a way that they looked cheaper than the original loan, but would, in fact, turn out more expensive for the borrowers and more profitable for the mortgage broker and the lender. Adjustable rate mortgages (ARMs) are a good example: an ARM may start with a low interest rate, but after two or three years the interest rate resets to a much higher rate. Borrowers are shown the initial, low interest rate while the higher interest rate is hidden in the small print of an illegible mortgage contract. Predatory loans were sold mostly in neighbourhoods with ethnic minority populations. Almost half of the loans in minority areas were predatory, compared to 22 per cent in white areas (Avery et al., 2007). African-Americans receive more than twice as many high-priced loans as Whites, 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 the city. These problems are not new: for at least ten years researchers have pointed out how 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 a major problem until house prices declined and the value of RMBS fell. Rescuing Fannie Mae and Freddie Mac was needed to guarantee the continuation of mortgage lending in the USA. Fannie and Freddie are so crucial to the entire system that without them the current mortgage market would fall apart. They are responsible for guaranteeing loans, for issuing “confirming” RMBS (i.e. low-risk, standardized securities), and have also bought so-called “private label” RMBS (i.e. securities that are not issued by Fannie and Freddie and include many subprime RMBS). Giving up on Fannie and Freddie would have meant giving up on the American economy. But as we all know the intervention of the federal government goes much further than the bailout of Fannie and Freddie. The Paulson plan of $700 billion is only part of a bigger effort to help the financial sector. Yet, very little of the money invested is designated to help defaulting homeowners from being foreclosed on. The American Housing Rescue and Foreclosure Prevention Act of 2008 will probably help up to 500,000 homeowners. The number of foreclosures for 2007-2009, however, will add up to seven to ten million. In other words, government is bailing out financial institutions that made major mistakes with billions of dollars, but does not even make enough funding available to stop the increase in the millions of homeowners that are being foreclosed on. The priority of the state is with exploiting financial institutions, not with exploited homeowners, even though a “foreclosure rescue plan” would have been much cheaper and could have guaranteed the flow of money from homeowners to RMBS investors, albeit at a lower rate of profit.

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 Reserve Bulletin, Vol. 93, pp. 73-109. Brooks, R. and Simon, R. (2007), “Subprime de´baˆcle traps even very credit-worthy”, Wall Street Journal, December 3, p. A1. Dymski, G.A. (2007), “From financial exploitation to global banking instability: two overlooked roots 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 real estate sector”, American Journal of Sociology, Vol. 112, pp. 231-75. Immergluck, D. (2009), Re-forming Mortgage Markets: Sound and Affordable Home Lending in a New 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”, Journal of Housing Research, Vol. 13 No. 1, pp. 31-50. Schloemer, E., Li, W., Ernst, K. and Keest, K. (2006), Losing Ground: Foreclosures in the Subprime Market 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 the United States”, Geografiska Annaler B, Vol. 88, pp. 105-32. About the author Manuel B. Aalbers (PhD) is a researcher at the Amsterdam Institute for Metropolitan and International 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 Special Issue of the International Journal of Urban and Regional Research on mortgage markets. His main research interest is in the intersection of finance, the built environment and residents. He has published on redlining, social and financial exclusion, gentrification, the privatization of social housing, financialization, and the Anglo-American hegemenony in academic research and writing. Manuel B. Aalbers can be contacted at: [email protected]

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Regulation and subprime turmoil Arvind K. Jain Department of Finance, Concordia University, Montreal, Canada

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Abstract Purpose – The global economy has entered what appears to be a very serious financial crisis for reasons other than force majeure. While the current focus has to be on preventing a repeat of the Great Depression, efforts must also be made to understand why the crisis came about in the first place. The objective of this paper is to demonstrate that the regulators should have known what the risks were and that these risks were large and systemic, and should have concluded that actions were required to prevent a serious global crisis. Design/methodology/approach – The article analyzes the developments in the US mortgage market to assess whether the chances of a crisis in the period before the crisis could have been assessed to be too remote to warrant concern. Findings – The evidence seems quite clear that, given the assessments of potential consequences of previous episodes in which concerted actions had to be taken to prevent the collapse of the global financial system, the regulators of the US economy should have taken steps long before the onslaught of 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 of financial markets, reducing chances of future crises of such proportions. Keywords Recession, Regulation, Financial markets, Derivative markets, Securities markets, United States of America Paper type Viewpoint

critical perspectives on international business Vol. 5 No. 1/2, 2009 pp. 98-106 q Emerald Group Publishing Limited 1742-2043 DOI 10.1108/17422040910938721

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

More than anything else, the subprime crisis is a story of hubris. It is a story of hubris at the highest levels of the economy, where those with an ability to take action chose to stay on the sidelines because of their belief that “the cost of slowdown today is much 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. Mortgages that could not have been repaid except under the most optimistic of assumptions were being issued without any controls. Those who issued the mortgages passed on the risks to others – mostly quite sophisticated investors – in the form of mortgage-backed securities without an independent assessment of risks by the buyers. These investors were responsible for their actions. Under normal circumstances, self-regulation should have worked. Buyers of these mortgages would suffer losses when the mortgages defaulted and the market system would have done its job. Unfortunately, in this case, there were two problems. First, some of these investors were financial institutions. Their individual losses create systemic risks for other participants in the financial markets. Second, the potential size of the defaults was becoming so large that the investors could not have been expected to pay fully for the losses. Their entire equity capital would have been less than the size of losses in the mortgage market under states of nature that would have been considered highly probable. They would leave a significant share of the losses for others to pick up. This is where regulators are supposed to come in – to prevent behavior that has negative externalities that create systemic risks. This is specially true when the externalities are large and when we have sufficient past experience that tells us that such eventualities are not merely figments of the imagination of those who stick to their beliefs in the superiority of socialist regimes. This paper traces the developments that led to the financial crisis and then evaluates the validity of charges against the “usual culprits”, The objective of this paper is to demonstrate that the regulators should have known what the risks were and that these risks were large and systemic, and should have concluded that actions were required to prevent a serious global crisis. Their hubris is the main cause of the crisis, which could have been avoided. Regulation of financial markets An 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 knowledge that economic systems that protect entrepreneurs as well as minority shareholders and creditors reach higher levels of development than those that fail to provide protection for all property holders. Such protection requires balancing too little regulation against too much of it. Too little regulation discourages entrepreneurs (they do not reap their due rewards under corrupt systems) and too much regulation acts as barriers to investments. Too little regulation exposes small investors to expropriation of their wealth by managers and majority shareholders, and too much regulation discourages them 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 other and with investors than non-financial firms. Given the ease and speed of communication 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 small disruption in their plans can create ripples throughout the financial system. Activities of each financial institution entangle hundreds of other institutions and one bad decision will require settlements between many institutions across legal and national boundaries. When Long Term Capital Management (LTCM) faced bankruptcy in September 1998 arising from its bad investment decisions, Federal Reserve officials intervened to develop a private sector rescue package not out of their concern for LTCM investors but because of their concern for potential consequences of the failure of LTCM on the financial markets (Dowd, 1999). Financial sector regulation is needed because activities of individual institutions can create negative externalities that give rise to systemic risks. Individual institutions may have to bear a major share of the consequences of their poor decisions, but poor investments in financial markets risk bringing down innocent bystanders. Central banks offer deposit insurance because banks cannot handle the consequences of too many depositors acting in the same fashion – howsoever rational from their own perspectives – in view of bad news. Financial regulators impose capital adequacy requirements to ensure that losses arising 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 not work when risks and rewards associated with one’s behavior are distributed asymmetrically. Regulations becomes necessary when those who benefit from risky behavior either do not bear the full costs of that risky behavior or have a subjective discount rate for the distant costs that is higher than that of the society which may have to bear those costs. This is why societies discourage smoking. We regulate speeding on highways because benefits are instantaneous; costs are underestimated due to “disaster myopia”. In financial markets, educated investors who make their own investment choices 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 only if some of the consequences of bad decisions are externalized to third parties and lead to the creation of systemic risks for the financial markets and other participants. The subprime crisis is an outgrowth of asymmetric distribution of risks and rewards. It is not clear why voluntary regulation was expected to work in this situation. Those who benefited from issuing poor quality mortgages – the originators of the mortgages – were not expected to lose if the borrowers defaulted. They had completely externalized the consequences of their decisions by selling these mortgages without recourse. They would have paid the price for issuing risky mortgages if those risks had been incorporated in prices of mortgage-backed securities. For reasons still not understood, rating agencies were classifying these securities as high quality paper even when they contained large shares of sub-prime mortgages[2]. There was no need for self-regulation on the part of mortgage issuers. In fact, self-regulation would have been irrational. The risk of these mortgages was being transferred to investors who seemed oblivious to the risks associated with the mortgages. The risk, however, had not disappeared. Regulators had to understand that buyers were taking on risks that they did not understand, assess possible consequences, including systemic risks under unfavorable states of nature, and take steps to protect the system. Regulators deluded themselves that markets were efficient in pricing risk even when given a free lunch. The economists’ joke that “there cannot be a dollar bill lying on the road because someone would have picked it up” works only on the lecture

circuit. Regulators suffered from the investors’ curse of “overconfidence in their abilities” and ignored everything that the past crises have taught us about how individuals and markets behave. The subprime crisis of 2007-2008 is not a crisis of greed or excessive financial innovations, it is a crisis of hubris. Rise and fall of NINJAs The origin of the present crisis lies in the deterioration of the lending standards for house mortgages in the USA. Market innovations and deregulation have changed the nature of this market dramatically over the past two decades. In the past, commercial banks used to issue mortgages and if the mortgage met the strict credit requirement of organizations like 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 of funds available for issuing mortgages to homeowners. The key was the quality of the mortgages. Two changes in this market lead to the growth of subprime mortgages. First, investors began to invest in mortgaged-backed securities issued by the government-sponsored enterprises like Fannie Mae and Freddie Mac. Second, banks themselves 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 issuers of mortgages. First, the trend in the house price appreciation accelerated towards the end of 1990s. Second, low interest rates following the short recession in 2002 had made investors search for high returns even if it meant higher risks. With rising house prices and investors’ appetite for risk, the stage was set for the rise of what became known as subprime mortgages. Rising house prices made it attractive to invest in houses, and banks that had entered the mortgage financing business began lending to borrowers who would normally not be considered credit-worthy. The quality of mortgages went down, banks created captive institutions called structured investment vehicles (SIV), and began to issue ever-increasing amounts of mortgage-backed securities. Once what had now become a high-risk mortgage lending business had been moved off the balance sheets through SIVs, banks were content to let mortgages be issued, combined to 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 repay the mortgages – the premise was that appreciation of house prices would provide the lenders sufficient cushion to recover their investments[3]. Figure 1 shows the movement of house prices in the USA as measured by the Case-Shiller home price index for ten or 20 urban areas. The 20-city index more than doubled between early 2000 and July 2006 – when it reached its peak. Figure 2 shows the growth of the mortgage market. Prime mortgages, which had accounted for almost 90 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 by 2006 dominated by subprime and Alt-A mortgages. At least the subprime part of these mortgages was unserviceable except under the most favorable conditions and would cause mortgage holders to lose money unless house prices continued to appreciate.

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Figure 1. House price movements in the USA

Figure 2. Mortgage market in the USA

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

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Figure 3. Delinquency rates of subprime mortgages

between the rates for 2003 and 2005). Delinquency rates rose consistently from 2004 to 2007. By the fall of 2008, 37 percent of mortgages issued in 2006 with a life of 27 months were delinquent. More than 20 percent of mortgages issued in 2007 were delinquent 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 subprime mortgages, had maintained their delinquency rates to mostly under 2 percent. Table I compares 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. By 2006, the subprime and Alt-A segment accounted for about $914 billion, or 41 percent of the mortgage market. By the end of that year it was also clear that house prices were taking at least a temporary breather (Figure 1). It would be rational to assume that if the appreciation of house prices did not resume, default rates on a market segment that

Year of issue 2003 2005 2005 2006 2007

Months since origination 60 12 30 27 12

Source: IMF (2008, data for Figure 1.8)

Original balance in delinquency (%) Prime Alt-A Subprime 0.4 0.1 0.9 2.1 1.1

1.7 1.0 7.8 16 7.9

15 6.1 29 37 17

Table I. Selected delinquency rates

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accounted for about one-tenth of the fixed income market of the entire economy would rise even further. Why were the buyers of these mortgage-backed securities not concerned about the risks? This remains a mystery. Formally, these securities were being rated by credit agencies and were given very high credit ratings. That, however, does not absolve institutional investors – manager of funds and of banks that were acquiring these securities – from the responsibility of assessing the risks themselves. No one has yet offered an explanation for why the rating agencies were providing the ratings that they did, or why the buyers themselves were willing to trust the rating agencies so completely. The situation during the period from the middle of 2006 to the middle of 2007 can be summarized as follows. A very significant portion of markets’ funds were being lent to subprime borrowers. The most derogatory term to describe these loans has been “ninja loans” – “no income, job or assets”. The only justification for lending was the expectation that house prices would continue to appreciate and the lenders would recover their funds from the appreciation of the prices when borrowers default. The borrowers really did not matter in these loans. The loans made sense under the assumption of continuous increase in house prices. The risks of these loans were not being borne by the issuers of the loans, but were fully transferred to independent and unrelated investors in the financial markets. There was considerable evidence, including Alan Greenspan’s own statement that the investors were not fully aware of the 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 to rise. Default rates on these mortgages had begun to rise. Should the default rates exceed certain critical levels, banks would suffer large losses. Could those losses have been estimated to be large enough to create systemic risks for the country’s or international financial system? The answer to this was provided by the failure of several hedge funds owned by banks in the middle of 2007. Greedy bankers and derivatives The three most common explanations for the subprime crisis seem to be the greedy bankers who paid themselves high salaries and bonuses with scant regard for the interests of the shareholders, innovations in the area of financial derivatives which allowed risks to be taken without full understanding of what was involved, and low interest 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 bad situation worse, it is hardly justified to shoot the messenger for being the bearer of the bad news. Bankers did not become greedy in 2003; they have always been greedy. What changed 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 numerous crises involving individual financial institution and rogue traders or managers that exposed the vulnerabilities of institutions (and the system, as in the case of LTCM) to uncontrolled or unsupervised use of these instruments. The use of now infamous credit default swaps by financial institutions to protect themselves from risks of mortgage-backed CDOs, risks that they did not understand, was merely a sideshow

to the subprime mortgages that were being given out. The crisis did not originate in these swaps – it originated in bad loans. The existence of swaps has made the situation difficult to untangle – something that had to be taken into account when the assets that were giving rise to the risks were being left unsupervised. The existence of these swaps and other derivatives is precisely the reason the regulatory authorities have 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 loss of a bad mortgage, and provided it has sufficient capital, no one would be any wiser. In a modern and very complex financial system as ours, the mortgage-issuing financial institution take steps to protect itself against the potential loss from that mortgage, and thus involves a host of other financial institutions in the risks associated with individual assets on its balance sheet. These are the externalities and the systemic risks 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 interest rate made the mortgage rates look very attractive! Low interest rates were the requirements of the economy at that time. Low interest rates on safe deposits are not a justification for buying high-return assets without assessing the risks associated with those returns and without ensuring that risks are being properly priced. The usual culprits are the easy targets. Concluding remarks Were the regulators of the economy, starting from the Federal Reserve and including the Office of the Controller of the Currency, Securities and Exchange Commission, Federal Deposit Insurance Corporation, Commodity Futures Trading Commission and Federal 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 to drag the rest of world with it? Behavioral economists now have very descriptive terms to explain actions of investors that challenge the traditional assumption of rationality on the part of economic agents. Two that come to mind in this crisis are “investor overconfidence” and “disaster myopia”. Investors – and in the case the regulators who believed in the omnipotence of markets – seem to think that their assumptions about the 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 apply to them. Investors and regulators also tend to believe that if a disaster has not happened for a while, it may never happen again. One’s subjective probability of an undesirable event falls below its objective probability as the most recent occurrence of that event recedes into the past. Never mind that banks had lent up to 70 percent of their capital to individual emerging countries just 20 years back under the assumption that “countries do not go bankrupt” and then spent a decade restoring their balance sheets when the countries did go bankrupt – that was the old system. Never mind the S&L crisis in the USA – we had solved that problem. From the time the subprime mortgages were being issued, it was clear that the only justification for these loans was the assumption that house prices would continue to rise at their recent rates well into the future. These loans were becoming a very significant part of the US financial market by 2005. The impact of defaults would not be confined to individual investors. There would be systemic consequences. The risks of 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 sophisticated investors to fool themselves into underestimating the risks of their investments. It is not clear how the regulators could put these developments together and still believe that self-regulation is all that was needed. Mortgages issuers could not care about systemic risks, investors believed that they would get out of the markets if things began to look bad, and regulators were too afraid to take the punch-bowl away when the 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 hedge funds, whose raison d’eˆtre is understanding risk and arbitraging minor imperfections in risk assessments by the market, blamed the “financial system” and accused rating agencies of having “facilitated the sale of ‘sows’ ears [. . .] as silk purses’ through ‘fanciful’ ratings of mortgage-backed securities’, completely setting aside their responsibility for assessment of risks 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 the rate of defaults. References Beattie, A. and Politi, J. (2008), “I made a mistake, admits Greenspan”, Financial Times, October 24, p. 1. Dell’Ariccia, G., Igar, D. and Laeven, L. (2008), “Credit booms and lending standards: evidence from the subprime mortgage market”, CEPR Discussion Paper No. 6683, Centre for Economic 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 author Arvind K. Jain is Associate Professor in the Department of Finance, Concordia University, Montreal, Canada. His current research focuses on corruption and poverty. His papers on corruption, debt crisis, capital flight, international lending decisions of banks, commodity futures markets and other topics have appeared in Journal of International Business Studies, Journal of Money, Credit and Banking, Economics Letters, Journal of Economic Psychology, Journal of Economic Surveys, and other academic journals. He has written two books, Commodity Futures Markets 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 of Corruption (2001). Arvind K. Jain can be contacted at: [email protected] or [email protected] To purchase reprints of this article please e-mail: [email protected] Or visit our web site for further details: www.emeraldinsight.com/reprints

The current issue and full text archive of this journal is available at www.emeraldinsight.com/1742-2043.htm

An economic wonderland: derivative castles built on sand

An economic wonderland

Jon Cloke Global and World Cities Group, Geography Department, Loughborough University, Loughborough, UK

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Abstract Purpose – This paper seeks to use the way in which markets in derivatives have developed historically to examine how neo-classical market-oriented economic theory has been used as a stalking-horse to create an illusionary market in the increasingly complex derivatives that have brought about the current global financial crisis and which threaten liberal democracy. Design/methodology/approach – The paper analyses the current global financial crisis using three separate themes in the development of derivatives themselves: the development of financial derivatives themselves; the subversion of risk analysis; and the co-opting of the concept and analysis of fair value by the financial services industry and its support network. These themes are used to show how self-regulation, supervision and the perception of risk have effectively been abandoned in the creation of an immensely profitable market based on an imaginary product. The study uses a combination of available facts and figures from professional literature and from international financial institutions and financial services organisations, as well as comparative analyses outlining financial services praxis. Findings – It is suggested that in an effectively unregulated, globalising capitalism this crisis and others like it are inevitable, and that the self-regulating capacities of capitalism suggested by neo-classical theory are non-existent. Originality/value – The paper uses facts and figures provided by the financial services industry to illustrate the poverty of the theoretical justification of the market in financial derivatives and the critiques of various practitioners and experts to point out that the crisis came foretold. Keywords Derivative markets, Recession, Financial markets Paper type Viewpoint

Virtually every aspect of conventional economic theory is intellectually unsound; virtually every economic policy recommendation is just as likely to do harm as it is to lead to the general good. Far from holding the intellectual high ground, economics rests on foundations of quicksand. If economics were truly a science, then the dominant school of thought in economics 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 of people and organisations to blame – short-sellers in the market, profligate home-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-dollar bonuses, hedge funds, the Fed, etc. Whilst the desire to find a culpable victim is perfectly understandable, it is also obvious that there is no “silver bullet” causal mechanism for this rapidly developing systemic failure. It is the purpose of this article to look at socio-political and cultural determinants of the current crisis, and to do so using three intertwined themes:

critical perspectives on international business Vol. 5 No. 1/2, 2009 pp. 107-119 q Emerald Group Publishing Limited 1742-2043 DOI 10.1108/17422040910938730

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(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 accountancy firms 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 by themselves are the main villains of the piece, if not to suggest that they clearly demonstrate a particular type of cultural and institutional systemic change which has taken place over the last three decades of the development of the supremacist ideology of globalising capitalism. It will be the suggestion of this article that the development of an enculturated, fundamentalist, market-orientated economic discourse since the 1970s has acted as a stalking-horse for the development of new, powerful, unrestricted and unregulated markets in the financial services sector, a stalking-horse which is by its very character anti-democratic. Thus far nothing particularly new – except that, with the development of financial derivatives and CDOs, such is the power of this supremacist ideology that a massive global market has developed in products which are essentially imaginary. Democracy underpinned by law or constitutional framework, liberal democracies of Western Europe or the constitutional democracy of the USA, work on the basis of the refreshing and realistic central precept of the inevitability of human fallibility – all power corrupts and democracy is the politics-made-flesh of that acceptance. There can be no end-state to democracy, it is and will always be a process undergoing continual fracture, revision and change. To paraphrase the quote about art often attributed to Mussorgsky, any given form of democracy is not an end in itself, but a means of addressing humanity; it is a process whose development is essentially characterised by endless subversion, thwarted and side-stepped by constant attempts from within and without to turn its frail authority into personalised or oligopolistic power to be used against it. Democracy by its very nature, therefore, both hosts and is vulnerable to a limitless range of counter-narratives, ranging from tiny political movements to global meta-narratives which, in being given freedom to thrive, may at any time metastasise into the illness that kills the host. Ideological fundamentalists of whatever kind (Christian, Islamic, nationalist/populist or left/populist, for instance) whose core discourses may allow them to use democratic mechanisms to achieve power within a given democratic type, may then use those same mechanisms to restrict or even close down democratic practices as being inimitable with contradictory core beliefs. Not all core discourses have arisen under democracies, of course, and many of them predate the earliest democratic ideas by thousands of years, but Western liberal/constitutional democracies are presently threatened by one of the youngest. The Trojan horse of theoretical market fundamentalism that has been made flesh since the 1970s has carried within it what this article will refer to as a market fantasist discourse, the presumption over and above the theoretical dominance of market forces that a market exists simply because we will it to be so and that its workings will be self-correcting and tend towards healthy equilibria, under no matter what circumstances.

The theoretical dictates of market fundamentalism have long been more dangerous than any other core discourse for different reasons. Amongst the most important of these are because it has become the doxa of governmental structures and actors across the North/West and because it has as a core belief a direct contradiction to the central precept of democracy discussed above – the idea that the unheeding self-interest of billions (in reality, of course, no more than a few thousand e´lite worldwide) acting together will lead to a universally prosperous and orderly society. It is in other words an essentially virtuous reading of psychosocial, sociological and anthropological tendencies[1]. In this late-twentieth and early twenty-first century mutation of the Classical economic school of the late nineteenth century, self-interest and conflict of interest have been inverted into virtues and internalised as good for the health of the body politic – human fallibility and the tendency towards corruption become in this reading essential motors for a prosperous society. It might seem a long step from an extemporaneous discussion of democracy and markets towards the present credit crunch (plus housing market collapse, plus banking collapse) and yet the connecting thread is firm and direct. Market fundamentalism contains a further anti-democratic core belief, which is its claim to scientific status and from that an objective, nomothetic capacity; to quote the then-Chief Economist to the World Bank, Larry Summers, at an IMF summit in Bangkok in 1991: “The laws of economics, it’s often forgotten, are like the laws of engineering. There’s only one set of laws, and they work everywhere”. There is no alternative under this reading of the laws of economics, and market fantasy has become one symptom of this delusionary illness 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 Christians who believe that their core religious beliefs are quite literally true and the only valid explanation for the world in which we live; these core essentialists from each religion would advance the argument that since they are the unique possessors of an incontrovertible truth, ideally all countries and all people should live under the rules espoused by that core discourse. It might be argued, however, that since the turf fights between Islamic and Christian belief systems from the seventh century onwards, few core discourses have come as close to being accepted on a global basis as market fundamentalism has after the collapse of the Socialist Bloc in 1989. Market fundamentalism comes close to being the first uber-modernist religion to confront post-modernism and post-structuralism; a core belief system that is still just a belief system, but which has overcome the traditional limitations of religion (and indeed of doubt) 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 extremely powerful. The best thing that central bankers can do for the world is to avoid such crises by providing 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 and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again (Bernanke, 2002).

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Whilst the Socialist Bloc existed, the governments of liberal Western democracies had of necessity to be politically restrained in their approach to market freedom; the threat of an alternative discourse-in-practice existed (however imperfect) and the governments of the Western Bloc had to exert caution over permissible amounts of what is now euphemistically termed “volatility” (whereas the central concern was of course the mass unemployment such volatility might incur and the resulting social/civil unrest that might accompany it, a more direct challenge to the system). Financial derivatives began a new era, however, with the deregulation of foreign currency 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 that Western 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 to become), an increasing confidence in the supremacy of globalising capitalism overthrew any perceived need for regulatory caution, especially during and after the triumphalist, monetarist regimes of Margaret Thatcher in the UK and Ronald Reagan in the USA. The terminal decline of the Socialist Bloc that culminated in the iconic event that was the fall of the Berlin Wall came accompanied in globalising capitalism by an increasing boldness in the development of market instruments. Two of the more important amongst these, the packaging of US mortgage bonds from the 1980s onwards to create collateralised debt obligations and the selling of default protection as credit default swaps from the 1990s (after the fall of the USSR) became two key actors in the current crisis. Accompanied by massive and sustained pressure towards the deregulation of all markets and stock exchanges in particular, what had been originally created as relatively crude instruments for hedging loan exposure developed rapidly into far more sophisticated instruments as the voracious demand for capital that fuelled the non-inflationary continuous expansion (NICE) era of the 1990s increased apace. By the turn of the century credit derivatives had multiplied so rapidly in type and extent and capital capture that they constituted a market of themselves, and the fall of Enron and what that had to say about the risk associated with credit derivatives was effectively dismissed by markets, institutions, academics and professionals alike. As an editorial piece 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 the Enron 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 which of course the amounts of capital now invested in them plus the maturity of what had become a market of central importance meant that, barring a disaster like the current one, they could not be allowed to be perceived as having failed, or as having an essential flaw. This perceived “coming of age” of the market was accompanied by an acceleration of the amount of money invested in this market, as Figure 1 shows. As we now know, whereas banks in particular were important participants in this market from the beginning, hedge funds became increasingly involved as they too became important players in global capital markets.

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Figure 1. Growth in credit derivatives

It is tempting but perhaps unhelpful to see financial derivatives as somehow synonymous with the buzzword that became “globalisation” – exotic, powerful and barely understood even by the most unquestioning fans. What is clear, however, is that so representative had they become as part of the market fantasist discourse that they were accepted almost universally (with a few notable exceptions such as George Soros and 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 becoming increasingly accepted as an accurate measure of credit quality, for instance in a special analysis produced by the Bank for International Settlements (BIS) in its Quarterly Review of June 2004. What had also become clear, however, was that no one state had the capacity to understand, much less supervise, the CDS market, whether it be through the more formal regulatory approach of the USA or the “light hand”, self-regulatory approach of the 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 market over state and, by extension and with reference to the initial premises of this paper, over state-channelled democratic oversight – the markets were themselves become democracy in action. At the same time (and again, with almost overwhelming irony) that the international financial institutions (World Bank, IMF etc.) were demanding more transparency, openness and accountability from the governments of countries in development, the globalising financial services sector was lauding the development of markets of increasing obscurity and impenetrability, over which regulation and oversight were all but impossible. The full scale and surreal nature of this market and its critical importance become apparent only when one looks at the BIS estimates for

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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 total derivatives exposure could wipe out the world’s capital base (Haas, 2008). Such is the continuing faith in the market fundamentalist discourse, however, that even with this critical leverage, in all of the current talk of “bail-outs” and “rescue packages” the concentration of governments around the world has been overwhelmingly on easing the short-term liquidity crisis, which is to say examining the symptoms of the illness whilst doing little to examine the long-term and fundamental causes. It might (for instance) be thought that the massive state intervention which the crisis has occasioned, the nationalisation of banks and the loans of taxpayers’ money to failing institutions should be accompanied by task forces not only 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 their future development. Despite lip-service being paid to regulation of these kinds, the emphasis is strongly on bail-outs and interest rate cuts – “recapitalisation” is the order of the day. The bankruptcy of this particular way of thinking, however, is obvious in phenomena such as the gap between the LIBOR inter-bank lending rate and central bank interest rates – banks know very well what they’ve been up to and they also now know 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 of leverage by individual investors pile up into leverage ratios of 100 plus; and add to this toxic mix investments in the most uncertain, obscure, misrated, mispriced, complex, esoteric credit derivatives (CDOs of CDOs of CDOs and the entire other alphabet of credit instruments) that no investor can properly price; then you have created a financial monster that eventually leads to uncertainty, panic, market seizure, liquidity crunch, credit crunch, systemic risk and economic hard landing (Roubini, 2007).

Market fundamentalism as an ideology purports to be nothing if not a moral analysis of human activity, and as a consequence of the necessity to justify the functioning of capitalism, 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 for human life. It is the only system that safeguards the freedom of the independent mind and recognizes the sanctity of the individual (Tracinski, 2002).

In the literature, the signalling of virtuous market functioning is transmitted by price structures 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. The precept of risk is another fundamental pillar in the moral basis of market fundamentalism, the idea that an entrepreneur undertakes to risk capital through analysing the market for a product, setting the price through use of available information on both market and product, and accepting the risk of losing capital that failure to get your calculations right may bring – it is not an exaggeration to say that

the premise of virtuous risk by the entrepreneur justifies by itself the profit-making underlying capitalism in this reading. However, the entire purpose of many derivatives (and the CDS in particular) has been to separate risk from product. Risk analysis, the commodification of and the trade in risk are specifically designed to factor out this virtuous uncertainty that justifies profit: 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 market fundamentalism) there is something called moral hazard, which must be avoided. The development of financial derivatives throughout the period since the 1970s (even the origins and growth of hedge funds themselves) which have evolved to reduce risks to the minimum, the continued failure and bail-out of national and regional banking systems (Mexico, Brazil, Asia, Turkey) plus unpunished failures (Russia (several times), Argentina, China, Nigeria, Thailand) notwithstanding (existential empirical evidence itself being non-existent) market fantasist belief in moral hazard must continue – because it acts as an essential theological support for market fundamentalism and its corollary, market discipline. For market fantasists and those tending towards the left/social democratic section of the political spectrum alike, the sight of US, European and UK governments effectively nationalising major actors in their banking sector during the ongoing credit crisis heralds nothing less than the “end of capitalism”, which some conservative commentators were predicting as long ago as September 2007 when the UK government took a share in the Northern Rock Building Society[3]. More fundamental perhaps is the way in which financial derivatives have developed since the 1970s, not merely as a counter to the risk-based functioning of capitalism and themselves weapons of mass moral hazard, but in virtual defiance of all precepts of risk analysis, if by risk analysis we understand a process that uses the systematic analysis of available information in identifying hazards. Using obscurantist equations to detach the element of risk on bundles of subprime mortgages so that they can be repackaged as products with an excellent credit rating, after all, is effectively reversing that process – taking a known product with a probabilistically high risk quotient and then obscuring that which is known about it. CDOs using subprime packages, after all, have the effect of making it impossible to determine the probability and frequency of mortgage default by mortgagee and the possessing bank alike, making it impossible to determine the severity of the likely consequences of that risk and thereby neutralising the two main determinants of which risk itself is a function. In an inversion of the separation of risk and uncertainty introduced 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 housing and consumer bubble of the mid-1990s onwards.

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Concealed by the fantasy-based performativity of espoused market-fundamentalist beliefs discussed above there is another interesting and powerful socio-political theme of existential globalization. This is the effective development over the last three decades of a supra-politics of hyper-accountancy, by which is meant the massive increase 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) in every area of nation-state activity, as well as those of international and multi-national quasi-governmental institutions. The concentration of oligopoly in the big four firms of the accountancy sector has given those firms shadow-state powers in vital areas of the business of the nation-state, by (for instance and with particular reference to the sanctification of conflict of interest (COI) mentioned at the beginning of the article) becoming at the same time national and international advisors on privatisation of state functions, prime engines for the carrying-out of that privatisation and then auditors of the effectiveness of that privatisation (UNISON, 2002) – in the UK and the USA, in addition, there has been a substantial ‘revolving door” for important political and governmental actors between employment and executive/non-executive positions within the big accountancy firms and employment in public office or government-contracted consultancies. Historically, the series of mergers that increased the power of the big accountancy firms in the last two decades of the twentieth century came accompanied by two further phenomena that at once increased the probability of COIs whilst at the same time pushing the firms to ignore them, in the search for audit clients and profits: these two phenomena were, firstly, that audit clients became increasingly sophisticated purchasers of accountancy services (Boyd, 2004) and thus shopped around more for the best deal; and secondly, because of the inherent flexibility in the interpretation of accounting standards, audit clients increasingly looked for accounting firms that would 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 the financial statements of the firm resembled as closely as possible the picture of the firm that the board wished to present. Both of these two factors increased pressures to lower prices 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 same time, the increasingly unhealthy nature of the auditor/client relationship was further exacerbated by the increase in numbers of accountants leaving their previous employer and taking up posts in the firms that they had previously been auditing, of which a particularly egregious example was the relationship between Arthur Andersen and Enron. One other logical consequence of the shrinkage in profit margins for auditing was the diversification of the big accountancy firms into (particularly) management

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 for credibility under the noses of skeptical investors, who know full well that the pile of manure is still fermenting somewhere (Peterson, 2008).

consultancy, in order to pursue non-audit profitability. Whilst this may have been logical, it of course represented an even starker COI, as a number of writers have pointed out over the years (see, for instance, Levitt, 2002); providing management services to a firm for which one also had responsibility for auditing was a direct conflict 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 accountancy institutions, as well as increases in direct political influence in the US and UK governments, initiatives to regulate auditor/client relationships by bodies such as the Auditing Practices Board in the UK and the Securities and Exchange Commission in the USA were stillborn, whilst the big accountancy firms continued to insist that if no direct evidence of COI could be produced, then none existed – even after incidents such as the destructive development of the relationship between Arthur Andersen and Enron. The institutionalisation and sanctification of COI by accountancy firms which we have briefly examined also took place at the same time as the explosion in numbers, types and complexity of financial derivatives outlined above. Auditors of course became involved in the trade in derivatives through the auditing service which they provided to financial services and banking institutions, only here the problems and the overt COIs were worse. Firms were being paid to audit banks/financial services firms to whom they were also contracted, in order to “properly audit” capital, cash flow and assets of the bank/firm, to asses the “fair value” for existing and new derivative products, a value which was arrived at by using selected information from and modelled by methods provided by the firm itself – effectively a perfect storm of COI. As discussed above, however, derivatives have increasingly been constructed to detach them from the inherent risk of the original product and the auditors had little knowledge 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 an increasingly important factor in marketing these surreal products[4]. With particular reference to the current credit crisis, then, the most relevant institutionalized conflict-of-interest for accountancy firms has been this role played in assessing “fair value” for financial derivatives, which will be examined after a brief contextual analysis; in more general terms (linking into the previous section) auditing services provided by firms of accountants have been consistently promoted as a technology for the management of risk (Mitchell and Sikka, 2002, p. 8) whereas the reality of the ways in which auditing has developed in the last three decades of the twentieth century mean that auditing is in increasing danger of becoming that thing of which it purports to be the cure, i.e. a creator rather than a manager of risk. As even Ernst & Young put it: . . . mathematically modelled fair values based on management predictions are not fair values as that term is generally understood, and their use raises many questions about the reliability and understandability of the information (Ernst & Young, 2005, p. 10)

By 2008, however, during the first financial crisis to occur under a predominantly fair value regime, opinions seemed to have changed. PricewaterhouseCoopers (2008, p. 9) still believes that: “Fair value measurement does not create volatility in the financial statements, 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 auditor is an objective and neutral analysis of the current state of affairs; there has been no pressure on the auditor to comply with board requirements, there is no close and mutually beneficial relationship between auditor and client, and the information provided 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 (as related above) the sheer volume of those still being traded, the big four accountancy firms continue to defend fair value calculations as being the best way to assess the value of such derivatives. Irrespective of “financial statement volatility, reporting the impact of risks and the judgements required to develop and implement fair value measures” and “the impact of fair value on regulatory measures of the capital adequacy of financial institutions” (PricewaterhouseCoopers, 2008, p. 9), “fair value yields a relevant measure for most financial instruments”. The big accountancy firms quite rightly point out that there were few complaints from financial services firms and investment banks concerning fair value when the markets were forging ahead; the complaints (akin to those about short selling) have all occurred since the roll-out of the subprime initiated financial crisis – which, given what is now known about the way that CDOs have been put together, is not really relevant to a consideration of whether the ways by which fair value is calculated can ever be sufficient for such surreal financial instruments. Markets through the looking-glass The aide said that guys like me were “in what we call the reality-based community,” which he defined as people who “believe that solutions emerge from your judicious study of discernible reality.” . . . “That’s not the way the world really works anymore,” he continued. “We’re an empire 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 you haven’t had much practice”, said the Queen. “When I was your age, I always did it for half an hour 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; the development of new public management, “revolving-door” government and the creation of a shadow financial services system offshore, among others. What is obvious from even a brief reading of these three themes, however, is that the causes behind the current crisis are multiple, complex and are the reflection of a rapid, massive and surreal 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 involved the global co-optation and active participation of states, multinational and international organisations, international financial institutions, professional

organisations and institutional bodies, governments, civil services, political parties and political actors over a short period of time. If the premises of this article are accepted then the willing suspension of disbelief on the part of so many important actors globally meant that this crisis was (along with others like it in the future) an inevitability. It is important to remember as well, however, that this was not just a willing suspension of disbelief concerning the market in derivatives, the market in bonds, the housing market and so on, if not a willing suspension of democratic control by which the governments of the North/West gave up control over their own governance to the random vagaries of shadowy market impermanence, an impermanence in which disaster was guaranteed. It is also highly unlikely that an enculturated ideology of such penetration and extent (in which the self-interest of so many important global actors is involved in praising 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 the derivatives market back into life, even though it is extremely likely that there are more problems than the infamous “sub-prime” derivatives lurking in these muddy waters. As Plan A, the US government has initiated the Troubled Assets Relief Program under Henry Paulson (ex-CEO of Goldman Sachs) who, along with sundry ex-colleagues from Goldman 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 of unwilling US taxpayers’ money, outside the reins of legislative understanding and control. In the light of $680,290,700,000,000-worth of global trade in derivatives, $700 billion to “rescue” the perpetrators of this market looks not only feeble but pointless. The recession that has already begun in the rich North/West is going to be made longer and harder 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 already predicting a prolonged, L-shaped recession of the type experienced by Japan from the 1990s up to 2005 (and now again). In the meantime, those same investment banks whose collapse occasioned sundry rescue packages use those rescue packages to pay themselves pre-collapse era bonuses, continuing to behave as if nothing had happened[5]. The enculturated norms of fundamentalist market fantasies have come home to roost – it should be for the last time but it almost certainly will not be. The development of market bubbles facilitated by the development of ever-more sophisticated financial instruments has spawned a growth industry and a global support network based on the power of belief, a belief that no government and no multinational or supranational institution need depend on something as boring and irritating as mere democracy. Instead, politician, minister, president, accountant and CEO alike, all need to take a deep breath, close their eyes and believe six impossible things before breakfast. Notes 1. In this text, market fundamentalism is used to describe that set of beliefs championed by followers in the first resort of Adam Smith, Mill, Hulme and then more latterly the Austrian

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3. 4. 5.

school of Hayek, of Reaganomics, Thatcher and Friedman, beliefs championed by powerful institutions such as the Adam Smith Institute in the UK, the American Heritage Foundation and the so-called “Chicago School” of economists. It must also be remembered that the fall of Enron was not the first time questions had been asked of derivatives; the failure of the hedge fund Long-Term Capital Management in the wake of the East Asia financial crisis in 1997 constituted a prior red light. Simon Heffer, “If we take away risk, then capitalism is finished”, The Daily Telegraph online, 19 September 2007. This despite the increasing concern being shown by the Federal Reserve Board over “managerial bias” and the over-inflation of value; see Bies (2004). See, for example, Bowers (2008).

References Bernanke, B. (2002), “Remarks by Governor Ben S. Bernanke: On Milton Friedman’s ninetieth birthday”, 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 of Credit Portfolio Managers General Meeting”, New York, NY, November 18, available at: www.federalreserve.gov/boarddocs/speeches/2004/20041118/default.htm (accessed 30 October 2008). Bowers, S. (2008), “Wall Street banks in $70bn staff payout: pay and bonus deals equivalent to 10% 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 Young Global, 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 nobody cares”, 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 a key 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 than priceable market ‘risk’”, RGE Monitor (Nouriel Roubini’s Global EconoMonitor), 15 August, available at: www.rgemonitor.com/blog/roubini/210688 (accessed 3 November 2008).

Suskind, R. (2004), “Faith, certainty and the presidency of George W. Bush”, New York Times Magazine, 17 October. Tracinski, R. (2002), “The moral basis of capitalism”, Capitalism Magazine, 26 June (see also The 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 and profit 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 Wall Street-Treasury-IMF complex”, New Left Review, Vol. I/228, March/April, available at: www.newleftreview.org/?view ¼ 1947 About the author Jon Cloke is Project Officer for EnergyCentral, an EC funded alternative energy project based in Central America, and a Research Associate at the Global and World Cities Network based at Loughborough University. He is based in Leicester at present and his research interests include corruption, the global development of financial services with special reference to microfinance and 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 Willmott University of Cardiff Business School, Cardiff, UK

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Purpose – This paper aims to examine the influence of neoliberalist deregulation on the rash of demutualisations of the 1990s. It explores the extent to which the demutualisation of two building societies – Northern Rock and Bradford & Bingley – and their subsequent demise in the wake of the credit crunch exemplify key features of the neoliberalist experiment, with a particular focus on their post-mutualisation business models. Design/methodology/approach – The analysis draws on literature that examines the neoliberal development of the financial sector and examines the media coverage of the financial crisis of 2007/2008 to study the discursive and material conditions of possibility for the development and implosion of the business models used by Northern Rock and Bradford & Bingley. Findings – The paper argues that the demutualisation of Northern Rock and Bradford & Bingley was part of a broader neoliberal movement which had processes of financialisation at its centre. By converting into banks, former building societies gained greater access to wholesale borrowing, to new types of investors and to the unrestricted use of financial instruments such as securitisation. The collapse of Northern Rock and Bradford & Bingley is interpreted in the light of their access to these new sources of funding and their use of financial instruments which were either unavailable for, or antithetical to, the operation of mutual societies. Research limitations/implications – The paper comments on the contemporary features and current 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 central argument. The intent of the paper is to provide a detailed analysis of the conditions and consequences of building society demutualisation in the context of the neoliberal expansion of the financial sector that resulted in a financial meltdown. It is hoped that this study will stimulate more critical analysis of the 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, and subsequent crisis, of financialisation, in which financial instruments such as collateralized debt obligations and credit default swaps were at its explosive centre, rather than to the expansion of subprime lending per se. Demutualisation is presented as a symptom of neoliberalism, a development that, in the UK, is seen to have contributed significantly to the financial meltdown. Keywords Building societies, Banks, Debt, Mortgage default, United Kingdom Paper type Viewpoint

It has been utterly, unbelievably, astonishing. Seeing the swift disappearance of the former societies 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). critical perspectives on international business Vol. 5 No. 1/2, 2009 pp. 120-140 q Emerald Group Publishing Limited 1742-2043 DOI 10.1108/17422040910938749

Introduction Mortgages and their providers have been at the centre of the current financial meltdown. In the USA, Fannie Mae (Federal National Mortgage Association) and

Freddie Mac (Federal Home Loan Mortgage Corporation) have been placed in the conservatorship of the Federal Housing Planning Agency. In the UK, the government has intervened to nationalise or part-nationalise a number of banks, including two specialist mortgage providers: Northern Rock and Bradford & Bingley. This intervention is a significant and integral part of a much bigger national and global picture. On 8 October 2008, the UK Chancellor announced that the government would be easing problems of liquidity (and ultimately solvency) threatening the survival of the other UK banks by making available £25bn to buy preference shares (in banks) or permanent interest-bearing bonds (in building societies), with another £25bn on standby. In addition, £200bn was being made available to banks to borrow with a further £250bn of debt being offered to enable the banks to refinance their loans. At the time 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 are using them to patch up their own balance sheets rather than to reopen flows of credit to borrowers, including businesses as well as actual and potential homeowners[1]. Northern Rock and Bradford & Bingley were, until the mid-1990s, mutual building societies[2], owned by and accountable to their members. At that time, there were over 100 independent societies. During the past 15 years, this number has diminished to around 50, mostly as a consequence of merger rather than demutualisation. A minority of societies, of which many were the largest mutuals, changed their ownership structure following a change and relaxation of regulations that began in the mid-1980s and continued through the 1990s. They converted into proprietary banks owned by and accountable to shareholders. Amongst these societies was Abbey National, which was the first to convert in 1989. It was later followed by a rash of conversions around 1997 when the Halifax, Woolwich and Alliance and Leicester converted. Today, none of these demutualised institutions exist[3]. Amongst these converters, Northern Rock and Bradford & Bingley prospered as wannabe banks as they expanded in a decade of abundant credit which fuelled a buoyant housing market where the supply of mortgages outstripped demand and competition between banks and building societies intensified[4]. In the following commentary, we explore the connection between demutualisation and the adoption of unsustainable lending practices and associated business models that, we contend, are symptomatic of global financialising frenzy and a subsequent meltdown exemplified in the seemingly limitless rise and then precipitous fall of the UK’s demutualised banks. We interpret this trajectory as an outcome of a neo-liberal experiment that, in the name of individual freedom, was constructed to revive the flagging fortunes of capitalism following an extended period of stalled growth during the 1970s. What this meant in terms of post-demutualisation[5] business practice can be briefly illustrated by comments made by a senior figure who worked for one of the proprietary banks during the first half of 2007 when cautious, mutual lenders like Nationwide cut back on their loans whilst the loan books of Northern Rock and Bradford & Bingley grew to record levels: Pulling back from the mortgage market now looks to have been a really smart bet, but we would have felt very uncomfortable with a strategy based on giving up market share and reducing lending. As it turns out, our shareholders would probably have thanked us for that approach, 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 taken in the first half of 2007; quoted in Prosser, 2007).

The neoliberal revival project was sold to UK and US electorates by the charismatic political figureheads of Reagan and Thatcher, and it was sustained thereafter by the Clinton and Blair administrations. As Blair’s Chancellor confidently crowed in November 1997: I am satisfied that the new monetary policy arrangements will deliver long-term price stability, and prevent a return to the cycle of “boom and bust” (Gordon Brown, former Chancellor of the Exchequer, quoted in Finkelstein, 2008).

The neoliberal formula for reviving capital accumulation has pushed relentlessly for the sovereignty market discipline and mechanisms (e.g. stock options and bonuses) as a replacement for failed Keynesian corporatism and state regulation. The goal has been to ensure a restoration and sustained reproduction of established structures of advantage that has been accomplished, in part, through the formation of new e´lites (Murphy, 2008), predominantly in the financial sector where those dubbed by Keynes as “coupon clippers” have enjoyed, at least until the meltdown began in 2007, a spectacular resurgence. Central to this process was a transfer of public assets to the private sector that has been a condition and a consequence of the rapid expansion of financial activity: Increasingly freed from the regulatory constraints and barriers that hitherto had confined its field of action, financial activity could flourish as never before, eventually everywhere. A wave of innovations occurred in financial services to produce [. . .] new kinds of financial markets 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 mortgage market as the apparent root cause of the meltdown in financial markets, it is perhaps unnecessary to say that this “everything” includes housing. What is much less evident is that mortgages, in the form of mortgage-backed securities (MBS), a form of collateralised debt obligation[6] (CDO), became a primary and highly profitable target of financial engineering. It is not simply that many people were sold loans that they would struggle to service when interest rates increased and property values stalled or fell. Rather, it is the way in which these loans were packaged up as MBSs as a basis for making further loans which, in turn, created a huge, unregulated market in credit default swaps[7] to hedge, or bet, against the risk of default on the MBSs. In the UK, a condition of possibility of such engineering was the relaxation of regulations enabling building societies to demutualise, and thereby gain increased access to wholesale markets[8]. Proprietary banks, including demutualised societies, have both greater access to, and considerable shareholder pressures to use, the wholesale markets as a means of expanding the scale and profitability of their businesses. Our commentary makes connections between “the financialization of everything” that includes home loans, the demutualisation of building societies, and the business models that relied upon the availability and reliability of sophisticated financial instruments. It is organised around three questions:

(1) Why did many building societies demutualise? (2) What effects did demutualisation have upon the business models of the demutualised companies? (3) What were the key elements of the neoliberal experiment that resulted in the financial 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 measures intended to stimulate economic activity by increasing competitiveness through economic 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 further contribute to the breaking of the monopoly of building societies in the mortgage market, thereby contributing to the development of a property-owning democracy in which, in principle, everyone has a personal investment in the unhindered reproduction of the capitalist system. In the neoliberal symbolic universe, the promotion of “individual rights” functions as a central nodal point around which necessity of the preservation of strong property rights, and their protection by the state, is structured (Harvey, 2007). Neoliberalism also promotes the use of stock incentive schemes to bridge the classic dividing line between ownership and management of companies, and prioritises financial over productive capital. In this sense, the demutualisation drive that occurred in the 1990s, facilitated by an expansion of securitisation in the mortgage market (in which demutualised societies become key players), formed an integral part of a process of financialisation which, in its broadest sense, has been characterised as the “increasing role of financial motives, financial markets, financial actors, and financial institutions” (Epstein, 2006 p. 3). Notably, the demutualised societies become more fully hedged financial institutions able to wholly embrace financial motives and participate more completely in financial markets. Before the 1986 Act, corporate governance of mutuals had relied on an “identity of interest” between lenders and borrowers. The prospect of demutualisation permitted – indeed encouraged – this connection to be severed. Why was demutualisation an attractive option? For the members of these mutual societies, there was the appeal of a substantial windfall that could amount to thousands of pounds, by signing a voting form which changed them from policy-holders into shareholders. For those who organised campaigns to demutualise the societies, there was the prospect of gaining control of considerable assets. These campaigners drew support from “carpetbaggers”[9] who invested in a society simply to be able to vote for conversion and thereby obtain windfall gains. Conservative and Labour administrations actively supported the demutualisation process. Notably, when the courts found a way of circumventing the qualifying two-year period for a member to make equity claims, intended as an anti-carpetbagger provision in the 1986 Act, the then Conservative government did not enact amending legislation to counteract this development (Tayler, 2003). But it was not just the account holders, campaigners and carpetbaggers who sought 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 mutuals stood to enhance their status as well as their rewards package as a consequence of conversion. For them, there was the prospect of mutating from low-profile mutual building 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 the prospect of the pay-off accompanying acquisition by another financial institution. As Christopher Rodriques, Chief Executive of Bradford & Bingley at the time of demutualisation, is reported to have said: When we float we are obviously responsible to shareholders and would look at any one who comes along with a large, cleared cheque (quoted in Ashton and Dey, 2008).

Bradford & Bingley’s directors were actually resistant to demutualisation but proved insufficiently well prepared and organised[10], unlike the Nationwide and Britannia, to resist it. At Nationwide, in contrast, the Chief Executive led a determined campaign that lasted several years to fight off carpetbaggers (Brian Davies, 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 and inattentive to their policy-holders, who would benefit from access to more diversified services, competitive loans and so on. As The Times put it, “opponents were compared to ‘steam train enthusiasts’, hopeless romantics trying to save a business model that had 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 publicly ridiculed. Commenting upon the demutualisation craze, an analyst of building societies for the investment bank UBS observed: They used words like “freedom to compete” and “access to capital,” but the main reasons were excessive pay, share options and testosterone’ (John Wrigglesworth, Building Society analyst for the investment bank UBS in the 1990s; quoted in Pollock, 2008a).

This underlines a certain attraction and excitement for the stock market that does not necessarily correspond to claims of efficiency (see Sta¨heli, 2007). As others have argued, processes of financialisation are a medium and outcome of a neoliberal symbolic universe in which it is assumed that financial markets are the best judges of 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 the real economy, acting as self-fulfilling prophecy [. . .] Financial markets [. . .] may create their own ‘fundamentals’”. Companies, but also governments, then are obliged to prove their credibility according to the confidence that financial markets show 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 and citizens. If the flight continues, then either the company becomes bankrupt as its credit drains away, or it is rescued by the states as the lenders of last resort, as has occurred in the cases of Bear Stearns and AIG, as well as Northern Rock and Bradford & Bingley.

What effects did demutualisation have on the business models of the demutualised companies? . . . the most vulnerable building societies are those that have the greatest exposure to specialist mortgages, high loan-to-value residential mortgage loans, concentration in commercial 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 services industries during the 1980s and 1990s, the market for mortgages in the UK underwent a seismic shift. From a situation where rather sleepy mutual building societies had dominated the market by providing similar, simple products on cautious terms, product offerings became more diverse and complex. Reflecting upon this period, a recent commentary in the Financial Times recalled how “Britain’s mortgage banks changed their business model and become heavily reliant on wholesale banking and securitisation. It was a mile away from the original Friendly Society model that lent out only what the members had deposited” (Augar, 2008). Under the Building Societies Acts of 1986 and 1997, mutuals were required to derive at least 50 per cent of funding from member deposits and to secure 75 per cent of their assets in residential property (Heffernan, 2005). This restriction opened up an opportunity for demutualised societies to increase their share of this market by making loans funded by borrowing from wholesale markets, especially during an era of abundantly cheap credit, to which the mutuals have comparatively limited access[12]. As the market mechanism kicked in, established building societies became increasingly aggressive in competing with new entrants, in the form of the banks, which now included the ex-mutuals. Products were often designed to win business from competitors by offering fixed rates and/or by lowering tariffs for the first year or more of the loan. So, in addition to the “churn” associated with the use of introductory offers 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 had previously excluded them from entering the housing market and thus from fully reaping the rewards of participation in a property-owning democracy. At the same time, on the supply side, there was both pressure and opportunity to supplement traditional sources of finance (that is, retail deposits) by going to the wholesale markets, which during this period were often awash with money prompted, in substantial part, by the dicing, packaging and sale of mortgages as mortgage backed securities (MBS)[13] available at low rates of interest. Intensifying competition and unparalleled growth fuelled by low interest rates and innovative products were hallmarks of the decade leading up to 2007. Responsive to shareholder pressure and executive ambition, growth was led by those demutualised societies that specialised in mortgages, notably Northern Rock and Bradford & Bingley, and by banks that had acquired or merged with demutualised societies[14]. Of these, HBOS, formed through a merger of the demutualised Halifax Building Society and Bank of Scotland, was the dominant player. When considering the rise and fall of Northern Rock and Bradford & Bingley, it is relevant to consider the fate of HBOS as its business model combined elements that they favoured – namely, reliance upon wholesale 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 mortgage product, ostensibly tailored to young professionals who were struggling to get a foothold 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 record as the best performing bank stock over the past three years (HBOS, 2006). A total of 18 months later, it was ignominiously part-nationalised, with the humiliating prospect of being 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 the wholesale markets and a business model created around weak sectors that a merger is not 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 of Northern Rock and Bradford & Bingley. HBOS is not only dependent upon wholesale money markets, as was Northern Rock and Bradford & Bingley, but was also exposed to risky housing, property and corporate lending markets, which has made it an unattractive proposition for nationalisation. At the right price, HBOS is nonetheless an appealing acquisition for Lloyds TSB, for whom the government, in order to avoid taking ownership of this sizable financial problem, was willing to bypass the merger rules which allow regulators to scrutinise and even block anti-competitive deals (Shoosmiths, 2008). Northern Rock At its peak, Northern Rock had become the eighth largest British bank. As 2007 arrived, it was seemingly riding high and, in June 2007 when its share price stood at 1,000p, it announced that it had sold mortgages worth £10.7bn, up 47 per cent on the same period in 2006[16]. Since its demutualisation in 1997, the Rock had grown rapidly[17] to become the fifth largest mortgage lender in the UK. It funded its aggressive expansion by heavy reliance on secured and unsecured borrowing, with about 50 per cent of its funding coming from securitization through its special purpose vehicle, Granite. Retail deposits and funds had fallen from 62.7 per cent at the end of 1997 to 22.4 per cent at the end of 2006. Despite its reliance on the wholesale sector, and as opposed to other banks, it did not insure itself sufficiently against the potential loss of liquidity (House of Commons Treasury Select Committee, 2008a). At the end of June 2007, former CEO Adam Applegarth explained its funding model, which was later called “a highly leveraged bet on interest rates” (House of Commons Treasury Select Committee, 2008b, Q 401), as follows: We do most of our borrowing in the wholesale markets based on Libor (London Interbank Overnight Rate)[18] but most of our lending is related to base rates. Over the last five months the gap between the two has been getting steadily wider, to the extent it was 69 basis points at 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 lending but, in contrast to Bradford & Bingley (see below), this did not become a major part of its activities. A key distinguishing characteristic of the Rock’s business model was its exceptionally high level of dependence upon, and exposure to, wholesale money markets, particularly in terms of securitising its mortgages. During the first half of

2007, Northern Rock expanded its business very rapidly as its net loans to customers increased by £10.7bn during this period (House of Commons Treasury Select Committee, 2008a). Following an increase in interest rates and an associated slow-down in house price inflation, the Rock issued a profits warning on 27 June 2007. Commenting upon the position, Adam Applegarth anticipated that profit growth would nonetheless be within the company’s targets of 15 per cent to 25 per cent for the second half of 2007, although more likely at the lower end of this range. He remained sufficiently confident to raise targets again in the medium term (Wearden, 2007; Attwood, 2007). And, in this, he was supported by most analysts, such as Goldman Sachs, 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 that had exposure to the US subprime market, the money markets started to dry up. At this time, Northern Rock’s exposure to the wholesale market (mostly securitisation, covered bonds and unsecured wholesale funding) was 73 per cent, while the wholesale exposure of Bradford & Bingley and HBOS was 42 per cent and 43 per cent, respectively[19] (The Telegraph, 2007). As the credit squeeze tightened, only the big diversified banks were able to raise wholesale funds, and they were finding it increasingly difficult and expensive. Within a week, officials at the Financial Services Agency and the Treasury alerted the Governor of the Bank of England to the effects of the credit squeeze on the Rock. On 4 September, the severity of the credit drought became evident as the Libor rose to its highest level in nine years. In similar circumstances, the European Central Bank and the Federal Reserve had moved to ease liquidity by pumping huge amounts into the banking system. In contrast, in the UK, the Governor focused upon the moral hazard of bailing out reckless lenders rather than upon the potential systemic risk associated with a reluctance to ease liquidity. This view was subsequently moderated, but not reversed, on 13 September when the Rock was granted emergency financial support[20]. The possible limitations of a business model that relied upon the wholesale money markets 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 lot of 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 of England had granted it emergency funding, the Rock’s share price dived by 32 per cent. In response, experts opined that “Northern Rock, which has £113bn in assets, is not in danger of “going bust’”. But customers clearly had their doubts, precipitating a run on the bank as they stampeded to withdraw their savings (BBC News, 2007). Six months later, in February 2008, Northern Rock collapsed after acquisition bids by the private sector (e.g. Virgin and Olivant) were eventually rejected by the government, and it was taken into public ownership. Bradford & Bingley Bradford & Bingley, formed in the mid-1960s from the Bradford Equitable Building Society and Bingley Permanent Building Society, was the UK’s second largest building society 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 was nationalised 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 had previously acquired Abbey and Alliance & Leicester. The combined costs of nationalising Bradford & Bingley and Northern Rock have been estimated to result in every 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 remain good for the second half as demand continues to drive the buy-to-let market. Increasing returns to shareholders through organic growth, portfolio acquisitions, and capital management will be our focus for the remainder of 2007 (Bradford & Bingley, 2007a).

A week earlier, Standard & Poor had identified Bradford & Bingley as being at particular 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 was reported to say that despite the market turmoil, the bank had been “resilient and resourceful” and was “now even better placed to take up opportunities in the market having disposed of its non-retail portfolios in line with its focus on retail mortgages and 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 in the buy-to-let market (Bradford & Bingley, 2007b). Less than 12 months later, in September 2008, the bank collapsed and its mortgage book was nationalised. Bradford & Bingley’s business model comprised a number of distinctive features. It was unique in being an independent intermediary in advising on and selling other providers’ mortgages in addition to its own offerings. Another feature was a propensity to diversify by purchasing businesses (e.g. estate agencies) and then selling them 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 it was negotiating Charcol’s sale for £10m. Unlike Northern Rock, Bradford & Bingley had increasingly specialised in buy-to-let and self-certified mortgages sold through its internet business Mortgage Express[21] that it had purchased from Lloyds TSB in 1997. Bradford & Bingley also bought large, risky but high-yield loan portfolios from General Motors in an attempt to increase its profitability. And in a further effort to satisfy its investors, Bradford & Bingley repeatedly slashed costs by cutting the payroll (UK Business Park, 2008). After Northern Rock and HBOS, Bradford & Bingley was most reliant upon, and exposed 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 to reduce its dependency, about 60 per cent of its business was funded through these markets (The Economist, 2008). When interest rates were low and house prices were rising apparently irreversibly, this proved to be a winning formula. In early 2006, the company’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 was largely funded from the wholesale market rather than from retail deposits (Yorkshire Post, 2007). Pressed by the demands of its shareholders and the ambitions of its directors, notably the chief executive, this stratagem was unequivocally embraced as a

“compelling route [as] the bigger banks had cornered the market in offering creditworthy borrowers the best deals” (Ashton and Dey, 2008). From mid-2007, the buy-to-let market, usually financed with debt, was badly affected by the drying up of credit and subsequent stalling and falling of the housing market, since activity in this segment is premised upon the presupposition of rising property values and rising rents. Indeed, Bradford & Bingley warned at the beginning of June 2007 that the sector was in crisis (Property Wire, 2008). As credit tightened and the cost of loans increased, landlords fell behind with payments. Compounded by an increase in mortgage fraud in the self-certification sector, Bradford & Bingley’s profits fell from £108m to £56m in the first months of 2008 compared to the same period in 2007 (Atkinson, 2008)[22]. In June 2008, there was a decline in its share price of 30 per cent. To increase liquidity Bradford & Bingley went to the market with a rights issue intending 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 the shortfall by taking at 23 per cent stake. The deal with TPG then fell through as Bradford & Bingley’s fortunes further deteriorated and Moody’s cut the bank’s credit rating[23]. Nonetheless, on the Friday before the bank’s collapse and its nationalisation the following Monday when it was unable to continue funding its operations (and was nationalised), 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 the febrile speculation goes, we do not comment on market rumours (Wallop and Griffiths, 2008).

Depositors believed otherwise, as £90m was withdrawn on the Saturday morning and a 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 of their demutualisation was pressure to develop a business model that would produce dividends and capital growth for their shareholders: There is a class of banks, all of them former mutuals that relied heavily on the mortgage market, 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 and Bradford & Bingley. Nor did Northern Rock diversify, for better or worse. Instead, the Rock relied very heavily upon the securitisation of its assets, in the form of mortgage-backed securities (MBSs) that in turn relied upon funding through wholesale money markets. While Northern Rock relied most heavily upon securitisation to fuel its profitable growth, securitisation was also a central plank of the Bradford & Bingley (and HBOS) funding models although, in their case, it was lending in subprime markets that contributed to their nationalisation (Bradford & Bingley) or expected takeover (of HBOS by Lloyds TSB). What were the key elements of the neo-liberal experiment that resulted in the financial meltdown exemplified in the demise of the demutualised banks? And then came the housing boom [. . .] mortgage-backed securities became the hot new investment. Mortgages were pooled together, and sliced and diced into bonds that were bought 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 meltdown has 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 the global 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 as cars), inflated the debt bubble. But it was not cheap money alone that unleashed the credit binge. It was the financialisation of the debt – that is, the use of financial instruments, notably collateralised debt obligations (CDOs) in the form of mortgage backed securities (MBSs), to transmute and leverage seemingly fixed assets into liquidity that could then be used to make further loans that would again be securitised to make further loans, and so on. Financial engineering also created new risks associated with the uncertainty as to whether the obligations would be honoured, thus giving rise to the development of a further tier of instruments called credit default swaps (CDSs). Common to both types of instrument is their privately negotiated character, the absence of regulation and the lack of a central reporting mechanism to calculate their value. CDOs involve the packaging up of assets that are sold as securities through special purpose vehicles (SPVs). A total of 50 per cent of Northern Rock’s funding came through securitisation using a special purpose vehicle (SPV), Granite (House of Commons Treasury Select Committee, 2008a). SPVs enable banks to tap the capital markets by securitizing a pool of assets (mostly MBSs, in the case of Northern Rock and Bradford & Bingley) by bundling together claims to future obligations of mortgage repayments such as principal and interest (Langley, 2006). The appeal of CDOs lies in the removal of illiquid assets from balance sheets. By selling on these assets to other financial institutions, which include insurance companies and pension funds as well as other banks, banks are able to restore liquidity. This has been described as a “tower of debt” that is: . . .made of the original sub-prime loans that have been piled together [at the top of this tower is the AAATranche, just below it is the AA Tranche, and so on down to the riskiest, the BBB Tranche . . . The banks had used these BBB Tranches] – the worst of the worst – to build yet another tower of bonds: a “particularly egregious” CDO. The reason they did this was that the rating agencies, presented by the pile of bonds backed by dubious loans, would pronounce most of them AAA. These bonds could be sold to investors – pension funds, insurance companies – who were allow to invest only in highly rated securities.

As Steve Eisman, a speculator who anticipated the meltdown and has made a huge fortune from shorting, or betting against, CDOs has commented the banks “weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford [. . .] They were creating them out of whole cloth. One hundred times over! 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 of Banking Supervision, had been intended to strengthen banks’ balance sheets by requiring them to weight assets according to their risks (FSA, 2008). But this requirement has had the unintended consequence of incentivising banks to devise means of removing risks from balance sheets rather than making them more

transparent. Instead of deriving most of their income primarily from the spread between the cost of their borrowing (e.g. from depositors) and their lending (to their creditors), fees and commissions from securitisation have become increasingly important. 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 they make and (b) with repackaging, it is very difficult to evaluate the risk of claims on these loans”. Whereas banks once had good reason to pay close attention to the risk of their own assets, securitisation has meant that this risk passes to those who buy CDOs (see Mian and Sufi, 2008). In principle, the rating agencies evaluate these assets but they are paid to do so by the banks and they do not bear the costs if their scoring is found to be over-optimistic. For example, Standard and Poor rated Bradford & Bingley as “a strong institution with good asset quality” in September 2007[24]. It is the difficulty of evaluating the risk of claims on CDOs that has stimulated the creation of an insurance market, in the form of CDSs. To hedge against, or place a bet on, CDOs losing their value (i.e. producing negative equity for retail lenders such as home owners and for the financial institutions buying the securitized loans), financial engineers have developed instruments for mitigating this risk. JP Morgan was the first bank 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 been famously 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 not covered 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 to have a good chance of defaulting on CDOs. Conversely, a speculator might calculate that default is highly unlikely and therefore obtain and sell a CDS in the expectation that premiums will be collected with minimal chance of having to pay out on insurance claims. Bear Stearns and AIG had trillions of dollars of CDSs on their books, leaving their trading partners exposed to their possible default – which is what explains the swift intervention of the Federal Reserve to limit the damage by issuing loans which these companies have been required to service at a premium rate. This might seem rather irrelevant in relation to the fortunes of UK demutualised building societies, but CDSs 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, insurance companies, hedge funds and others bought were over-rated and ended up falling precipitously 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 of insurance that these pools would, or wouldn’t, default. The sellers of this insurance (AIG is one 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 the markets for CDOs and CDSs that has produced a volte face by banks as, in an effort to shore up their balance sheets, they have hoarded cash, including that made available to them by central banks. A preoccupation with their liquidity has been prioritised above making loans to the likes of Northern Rock whose business model, with its extreme reliance 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 the financialisation dominated by the explosive growth of (now toxic) CDOs and CDSs – exposure to the risks associated with these instruments has led banks to retain their assets in order to preserve liquidity and avoid insolvency. Those wannabe banks – Northern Rock, Bradford & Bingley and also to a lesser degree HBOS – have been unable to transform their highly illiquid assets into the cash required to fund their ongoing business. When they have not collapsed and been nationalised, they have been rescued and propped up by government loans in the form of preference shares. In contrast, the business models favoured by proprietary companies were simply off-limits to mutual building societies, which are subject to guidelines and monitoring by the FSA to meet targets of liquidity[26]. Conclusion The best argument for mutuality is blindingly simple – a building society is owned by its savers and borrowers, so its sole purpose is to serve them. That goal is not complicated by a conflicting need to satisfy the Square Mile (Sutherland, 2008)[27].

Our central thesis has been that the key to understanding the current financial meltdown is not the rapid evaporation of cheap credit, popularised as the “credit crunch”, but the rise of financial instruments, in the form of CDOs and CDSs, that have been used to supercharge the borrowing process. Notably, high-risk, “subprime” loans on 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 of home 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 the supply of mortgage credit. The expansion of supply affected sub-prime customers who were traditionally marginal borrowers unable to access the mortgage market [. . .] The changes caused a subsequent spike in default rates, which have in turn depressed the housing market and 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 financial innovation a primary driver of the expansion of financialization into ever-increasing areas of social organization” (Montgomery, 2006, p. 305). As we noted earlier, Northern Rock’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 economy in which “downturns are now likely to result from a loss of confidence in the equity market rather than from inflation in the goods market, rapid credit growth over investment, and financial imbalances become all important” (Aglietta and Breton, 2001, p. 434). Economic crisis now stems from unpaid debts because accumulated capital does not require the prior settlement of debts. Bradford & Bingley’s and especially Northern Rock’s highly geared business models illustrate this point. Thus, the current financial crisis is essentially a crisis and consequence of financialisation as such (see also Blackburn, 2008). It is questionable, however, whether the directors of these demutualised companies could be expected to adjust rapidly and successfully to a very different financial terrain from that encountered by mutual building societies. It has been suggested that:

. . . 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 and securitizations. Governments and regulators were easing off the brakes in respect of capital adequacy, disclosure and intervention. Hedge funds moved shareholder activism from a minority pursuit practiced by maverick raiders to a mainstream activity and companies could not afford to slip. Benign economic conditions and low interest rates encouraged leverage and risk-taking (Augar, 2008).

Beholden to shareholders who prioritised dividends and profitable growth, the demutualised banks were under great pressure to meet these demands. The stratagems devised by Northern Rock and Bradford & Bingley were highly successful in relieving this pressure, at least in the short-to-medium term. They were compelled to keep issuing home loans funded by the wholesale markets and, in Bradford & Bingley’s case, further increased its already high exposure to the subprime segment at a time when the mutuals and more diversified banks (e.g. HSBC, Barclays, Lloyds TSB) had the luxury of opting to cut back on their mortgage business. Reflecting upon Nationwide’s decision to restrict the issuing of loans in anticipation of a stalling in house price inflation, its retail director, Stuart Bernau, stated that “we took the view at the beginning of this year [2007] that our rivals were driving down pricing, loosing affordability constraints and sacrificing quality for market share” and went on by emphasising the importance of sticking to a “very basic principle despite losing market share, in the light of these developments” (Prosser, 2007). Astute investors in Northern Rock and Bradford & Bingley would have realised that the business models developed by these banks were products of expediency and opportunism that could not be sustained when interest rates increased and/or credit tightened. What was more difficult to anticipate without a working knowledge of the role of securitisation was the speed at which these businesses would be enveloped and then wiped out in the turmoil of the meltdown. In periods of high liquidity in money markets, mutuals’ restricted access to these markets makes it more difficult for them to compete with banks, although this handicap is compensated by the absence of shareholders demanding dividends and/or capital gains and the associated threat of hostile takeover bids. When liquidity tightens or freezes, mutuals are much less exposed – in two respects. First, their capped reliance upon wholesale money markets inhibits involvement in the sale of subprime mortgages, so their asset base is comparatively protected. Second, when capitalism enters one of its periodic bouts of crisis and panic, mutuals continue in business because 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 their business model is, like the steam railway, immune to high-voltage power failures. Over and above these considerations, the primary obligation of directors of these societies is to their policy-holders who are generally risk-averse, passive and to a degree “locked in”. Mutuals are not beholden to footloose shareholders and speculators who, if they are sufficiently shrewd, are alert to the limitations of business models that are capable of delivering strong performance only while conditions allow. Where dark clouds form, there is usually a silver lining. In this case, it is the mutual building societies that have profited from the meltdown of financial markets. Even for 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 larger societies, such as the Nationwide and Yorkshire. In general, mutual societies that had been declared marginal, if not dead, in the wake of the demutualisation wave of the 1990s have been the principal beneficiaries of the financial turmoil. As a pertinent indicator of resurgence of the mutuals, in the first half of 2008, they received almost double 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 to the UK government’s 12 per cent. Why would Barclays want to part-nationalise itself more expensively to two Middle Eastern states? The answer would seem to be that it is desperate for the funds but, unlike most of its rivals, sufficiently strong to pay a premium in order to avoid the risk of having its “commercial freedom” curtailed, including the payment of salaries 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 and other financial services, especially mortgage lending. The term “building society” first arose in 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 today building societies actively compete with banks for most banking services, especially mortgage lending and deposits accounts. As of 2008, there are 59 building societies in the UK with total assets exceeding £360 billion. Every building society in the UK is a member of the Building Societies Association (Wikipedia, 2008). 3. In 2002, Halifax was acquired by Bank of Scotland (BOS) to become HBOS, a decision that contributed 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 Leicester acquired 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 for their interest in acquiring converted banks. 5. Demutualisation is the process by which building societies and mutual insurers convert themselves from mutual organisations (owned by their members/customers) to profit-making companies which distribute profits to their shareholders (Finance Glossary, 2008). 6. Collateralised debt obligations, or CDOs, are sophisticated financial tools that repackage individual loans into a product that can be sold on the secondary market. These packages consist of auto loans, credit card debt, or corporate debt. They are called collateralised because they have some type of collateral behind them. CDOs are called asset-backed commercial paper if the package consists of corporate debt, and mortgage-backed securities if 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 the transfer of third party credit risk from one party to the other. One party in the swap is a lender and faces credit risk from a third party, and the counterparty in the credit default swap agrees to insure this risk in exchange of regular periodic payments (essentially an insurance premium). If the third party defaults, the party providing insurance will have to purchase from the insured party the defaulted asset. In turn, the insurer pays the insured the remaining interest on the debt, as well as the principal (Investor Words, 2008).

8. Access to the wholesale market was facilitated by the 1986 Building Societies Act, which enabled societies to demutualise, thereby allowing greater leverage, unrestricted securitisation and access to new types of investors (e.g. institutional investors). Building societies retaining their mutual status have remained bound by comparatively tighter restrictions which make them predominantly reliant upon a more reliable but less financially rewarding flow of retail deposits. 9. The conversion of Bradford & Bingley, which was the only building society to convert against managerial advice, was blamed by managers on the actions of carpetbaggers (see Heffernan, 2005). 10. The directors foiled the first demutualisation attempt butsuccumbed to the second attempt led by a plumber who successfully forced the vote in 1999 when the line taken by the directors 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 2 from A for exposures to second charge loans or loans secured on the borrower’s home, which it anticipated would result in increased defaults but also in more severe losses than previously expected. West Bromwich was also downgraded to A 2 in recognition of its rapid 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 the commercial sector. Notably, as a consequence of “impairment charges in relation to commercial and specialist lending due to the deteriorating property market” (Cheshire Building Society Merger with Nationwide Building Society, Merger Notofication Stement Required by Schedule 8A to the Building Societies Act 1986, paragraph 1), the Cheshire and also the Derbyshire Building Society have merged with the largest UK mutual, the Nationwide. 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 Building Society, its takeover by Yorkshire Building Society was precipitated by its holding of £10m in collapsed Icelandic banks. 13. A mortgage-backed security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages. These securities must be grouped in one of the top two ratings as determined by an accredited credit rating agency, and usually pay periodic payments that are similar to coupon payments. Furthermore, the mortgage must have originated 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 of financial and related services to their base of account holders. Bradford & Bingley initially took 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 mortgage lending, with a specialisation in the buy-to-let segment. 15. The HBOS stock price has continued to plummet, so making the intended rescue by Lloyds TSB 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 its lending during this period, which reduced from £5.6bn in 2007 to £3.3bn as their “rivals were driving down pricing, loosening affordability constraints and sacrificing quality for market 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 of assets on its consolidated balance sheet, containing mainly secured lending on residential property (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 of retail deposits. 20. Mervyn King, Governor of the Bank of England, said shortly after the bail-out of Northern Rock that rescuing institutions that have taken on too much risk would involve “moral hazard”, 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 the money markets to reduce the cost of inter-bank lending.) 21. Mortgage Express is celebrated in a UK Department of Industry case study on quality and excellence, where its strategy is noted as “provid[ing] market leading products in such segments and Let & Buy, Buy-to-Let, Negative Equity, 100% and Self-Employed, delivered with a first class service“ (Business Balls, 2008). 22. The mortgages that are particularly troubling for Bradford & Bingley are those acquired by other 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 mortgages were 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’s liquidity position, although sound, was not as strong as we expected after the salee of various loan books” (Money Marketing, 2008). In its explanation of why it had downgraded Bradford & Bingley’s credit rating, Moody’s noted that the company was contracted to acquire up to £350m of mortgages a quarter from GMA and that this did not bode well for funding costs: “These mortgages have displayed a significantly faster deterioration of asset quality than the own-originated loan portfolio of Bradford & Bingley“ (Moody’s; quoted in Kennedy, 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 securitisation in order to raise much needed funding. 25. Notably, the insurance company AIG’s exposure to CDSs contributed to its collapse and nationalisation. 26. In December 2007, the FSA found building societies were well above that level or their own targets (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, to institutional shareholders. References About.com (2008), “CDOs (Collateralized Debt Obligations)”, available at: http://useconomy. about.com/od/glossary/g/CDOs.htm (accessed 2 November 2008). Aglietta, M. and Breton, R. (2001), “Financial systems, corporate control, and capital accumulation”, Economy and Society, Vol. 30 No. 4, pp. 41-90. Aldrick, P. (2008), “Bradford & Bingley’s problems blamed on funding model”, available at: www.telegraph.co.uk/finance/financetopics/financialcrisis/3088607/Bradford-andBingleys-problems-blamed-on-funding-model.html (accessed 29 October 2008). Argitis, G. and Pitelis, C. (2008), “Global finance and systemic instability”, Contributions to Political Economy, Vol. 27, pp. 1-11. Ashton, J. and Dey, I. (2008), “Bradford & Bingley’s final moments”, available at: http://business. timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article4837596.ece (accessed 28 September 2008).

Atkinson, R. (2008), “Bradford & Bingley announcement sparks share plunge”, available at: www.moneywise.co.uk/news-views/2008/06/02/bradford-bingleys-unveils-finance-plan (accessed 31 October 2008). Attwood, K. (2007), “Northern Rock hit by housing slowdown”, available at: www.independent. co.uk/news/business/news/northern-rock-hit-by-housing-slowdown-458768.html (accessed 31 October 2008). Augar, P. (2008), “The big bang model that blew up in our faces”, available at: www.ft.com/ cms/s/0/247923f8-8d8e-11dd-83d5-0000779fd18c.html?nclick_check ¼ 1 (accessed 28 September 2008). BBC Business (2007), “Northern Rock ups sub-prime rate”, available at: http://news.bbc.co.uk/1/ hi/business/6961620.stm (accessed 27 October 2008). BBC News (2007), “Northern Rock shares plunge 32%”, available at: http://news.bbc.co.uk/1/hi/ business/6994328.stm (accessed 27 October 2008). BBC News (2008), “Treasury to nationalise B&B bank”, available at: http://news.bbc.co.uk/1/hi/ world/7640143.stm (accessed 28 October 2008). Blackburn, R. (2008), “The subprime crisis”, New Left Review, Vol. 50, March/April. Bradford & Bingley (2007a), “Pre-close briefing 21 June”, available at: www.bbg.co.uk/bbg/ir/ publications/rp2007/trading2007/2007-06-21/2007-06-21.pdf (accessed 27 October 2008). Bradford & Bingley (2007b), “Pre-close briefing 29 November”, available at: www.bbg.co.uk/ bbg/ir/publications/rp2007/trading2007/2007-11-29/2007-11-29.pdf (accessed 27 October 2008). Business Balls (2008), “Case study: Mortgage Express”, available at: www.businessballs.com/ dtiresources/Mortgageexpress_TQM_case-study.pdf (accessed 28 October 2008). Chick, V. (2008), “Could the crisis at Northern Rock have been predicted? An evolutionary approach”, Contributions to Political Economy, Vol. 27 No. 1, pp. 115-27. Davies, G. (2007), “The roots of moral hazard”, available at: www.guardian.co.uk/commentisfree/ 2007/sep/15/comment.comment (accessed 30 October 2008). (The) Economist (2008), “Death of a one trick pony”, available at: www.economist.com/world/ britain/displaystory.cfm?story_id ¼ 12342543 (accessed 28 October 2008). Epstein, G.A. (2006), “Financialization and the world economy: introduction”, in Epstein, G.A. (Ed.), Financialization and the World Economy, MPG, Bodmin. Ferreira-Marques, C. (2008), “Fitch warns on outlook for UK mutual lenders”, available at: www. reuters.com/article/rbssBanks/idUSL2299083120080722 (accessed 30 October 2008). Finance Glossary (2008), “Demutualisation”, Vol. 2, available at: www.finance-glossary.com/ terms/demutualisation.htm?id ¼ 1654&ginPtrCode ¼ 00000&PopupMode ¼ (accessed 2 November 2008). Finkelstein, D. (2008), “No return to boom and bust, eh?”, available at: http://timesonline.typepad. com/comment/2008/09/boom-and-bust.html (accessed 19 September 2008). 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). FSA (2008), “Capital Requirements Directive/Basel 2”, available at: www.fsa.gov.uk/Pages/ About/What/International/basel/index.shtml (accessed 30 October 2008). Gilani, S. (2008), “The real reason for the global financial crisis . . . the story no one’s talking about”, available at: www.moneymorning.com/2008/09/18/credit-default-swaps/ (accessed 28 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 next battleground”, 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”, Journal of 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). House of Commons Treasury Select Committee (2008a), “The run on the Rock”, 5th Report on Session 2007-08: Volume I, Report together with Formal Minutes, 24 January. House of Commons Treasury Select Committee (2008b), “The run on the Rock”, 5th Report on Session 2007-08: Volume II, Written and Oral Evidence, January 24. Investopedia (2008), “Mortgage backed security – MBS”, available at: www.investopedia.com/ terms/m/mbs.asp (accessed 2 November 2008). Investor Words (2008), “Credit default swap”, available at: www.investorwords.com/5876/ credit_default_swap.html (accessed 2 November 2008). 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 %7BB 7F3BC1C-94CA-4931-B3A9-FB12184FF5C0%7D (accessed 31 October 2008). Langley, P. (2006), “Securitizing suburbia: the transformation of Anglo-American mortgage finance”, Competition and Change, Vol. 10 No. 3, pp. 283-99. Lewis, M. (2008), “The End”, available at: www.portfolio.com/news-markets/national-news/ portfolio/2008/11/11/The-End-of-Wall-Streets-Boom (accessed 30 October 2008). Mian, A.R. and Sufi, A. (2008), “The consequences of mortgage credit expansion: evidence from the 2007 mortgage default crisis”, available at: http://papers.ssrn.com/sol3/papers. cfm?abstract_id ¼ 1072304 Money Marketing (2008), “Standard & Poor’s places Bradford & Bingley on negative creditwatch”, available at: www.moneymarketing.co.uk/cgi-bin/item.cgi?id ¼ 159347&d ¼ 340&h ¼ 341&f ¼ 342 (accessed 30 October 2008). Montgomery, J. (2006), “The financialization of the American credit card industry”, Competition and Change, Vol. 10 No. 3, pp. 301-19. Murchie, K. (2007), “Bradford & Bingley have headstart on credit crunch”, available at: www. investmentmarkets.co.uk/20071130-1297.html (accessed 26 October 2008).

Murden, T. (2008), “Business comment – only merger will keep HBOS in the game where nationalist card counts for nothing”, available at: http://scotlandonsunday.scotsman.com/ business/Business-Comment–Only-merger.4606586.jp (accessed 29 October 2008). Murphy, J. (2008), The World Bank and Global Managerialism, Routledge, London. Peston, R. (2008), “Barclays protects its bankers’ pay”, available at: www.bbc.co.uk/blogs/ thereporters/robertpeston/2008/10/barclays_protects_its_bankers.html (accessed 31 October 2008). Philips, M. (2008), “The monster that ate Wall Street”, available at: www.newsweek.com/id/ 161199 (accessed 31 October 2008). Pollock, I. (2008a), “Not such a good idea after all?”, available at: http://news.bbc.co.uk/1/hi/ business/7641925.stm (accessed 30 October 2008). Pollock, I. (2008b), “Why the B&B is subject to takeover speculation”, available at: http://news. bbc.co.uk/1/hi/business/7629107.stm (accessed 31 October 2008). Property Wire (2008), “No crisis in UK buy-to-let industry, experts claim”, available at: www. propertywire.com/news/europe/no-crisis-in-uk-buy-to-let-industry-200806141143.html (accessed 31 October 2008). Prosser, D. (2007), “The return of the building society: credit crisis, what credit crisis?”, available at: www.independent.co.uk/news/business/analysis-and-features/the-return-of-thebuilding-society-credit-crisis-what-credit-crisis-760127.html (accessed 30 October 2008). Ram, V. (2007), “Bradford & Bingley hurt by higher rates”, available at: www.forbes.com/ markets/2007/06/21/bradford-bingley-mortgage-markets-equity-cx_vr_0621markets19. html (accessed 28 October 2008). Shoosmiths (2008), “Government set to bypass competition rules and push through HBOS/Lloyds merger”, available at: www.shoosmiths.co.uk/news/1522.asp (accessed 31 October 2008). ¨ konomie, Suhrkamp, Frankfurt. Sta¨heli, U. (2007), Spektakula¨re Spekulation: Das Popula¨re der O Sutherland, R. (2008), “Were our mutual friends a safer bet?”, available at: www.guardian.co.uk/ business/2008/jun/08/banking.demutualisation (accessed 30 October 2008). Tayler, G. (2003), “UK building society demutualization motives”, Journal of Business Ethics, Vol. 12 No. 4, pp. 309-11. (The) Telegraph (2007), “Is Northern Rock rocked or still rock steady to grow profits?”, available at: www.telegraph.co.uk/finance/markets/2814223/Is-Northern-rocked-or-still-rocksteady-to-grow-profits.html (accessed 31 October 2008). (The) Telegraph (2008), “Mergers are on the menu as building societies suffer”, available at: www.telegraph.co.uk/finance/newsbysector/banksandfinance/2795485/ Mergers-are-on-the- menu-as-building-societies-suffer.html (accessed 5 November 2008). (The) Times (2008), “Home truths”, available at: www.timesonline.co.uk/tol/comment/ leading_article/article4143964.ece (accessed 30 October 2008). UK Business Park (2008), “Bradford & Bingley”, available at: www.ukbusinesspark.co.uk/ bry87488.htm (accessed 30 October 2008). Wallop, H. and Griffiths, K. (2008), “Financial crisis: Bradford & Bingley to become latest victim”, available at: www.telegraph.co.uk/finance/financetopics/financialcrisis/3088687/ Financial-crisis-Bradford-and-Bingley-to-become-latest-victim.html (accessed 29 October, 2008). Wearden, G. (2007), “Northern Rock says higher rates will hamper profit growth”, www. guardian.co.uk/business/2007/jul/25/northernrock.banking (accessed 31 October 2008).

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Wikipedia (2008), “Building society”, available at: http://en.wikipedia.org/wiki/Building_society (accessed 2 November 2008). Yorkshire Post (2007), “Bradford & Bingley beats the slowdown”, Yorkshire Post, 27 July. 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 of UK 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 (accessed 18 December 2008). Munro, M. (2005), “Need a loan for any purpose? Sub prime lending in the UK”, ENHR Conference, 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 European Review, Vol. 12 No. 4, pp. 394-402. About the authors Robin 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 is currently a PhD candidate at Cardiff Business School, University of Cardiff, UK undertaking a study 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. He has 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 of studies of the accounting industry (with Prem Sikka and David Cooper). He has served on the editorial boards of Accounting, Organizations and Society, Critical Perspectives on Accounting and Accounting, Auditing and Accountability Journal, and he currently serves on the boards of Academy of Management Review, Organization Studies, Journal of Management Studies and Organization. Hugh Willmott is the corresponding author and can be contacted at: [email protected]

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Building resilience to international financial crises: lessons from Brazil Andre´ Filipe Zago de Azevedo

Resilience to international crises 141

Universidade do Vale do Rio dos Sinos (UNISINOS), Sa˜o Leopoldo, Brazil, and

Paulo Renato Soares Terra School 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 past decade, today Brazil is much more resilient to international financial crises than in the 1990s. Design/methodology/approach – The paper presents preliminary macroeconomic data in a country case study. Findings – The paper concludes that the initial impact of the current international financial crisis on Brazil has been much less severe than similar crisis episodes in the past. Research limitations/implications – Given that the crisis is still unfolding, the paper presents only preliminary data regarding its impact on emerging markets. Practical implications – The paper suggests that emerging markets should adopt flexible exchange rate regimes and stable macroeconomic policies as a means to reduce their exposure to international shocks. Originality/value – The paper makes an initial diagnosis regarding the impact of the international financial crisis on emerging markets that have adopted sensible economic policies, and is of interest to scholars, business people, and policymakers in developed and emerging countries. Keywords International finance, Financial markets, Emerging markets, Brazil Paper type Viewpoint

1. Introduction Some analysts point out that the current financial crisis may be the most serious since the Great Depression of the early 1930s – or even more serious than that. Others argue that it should be at least deeper than those which occurred in the 1990s. Although it is too early to assess its full impact on the economy, it has resemblances to previous crises. First, like the 1929 crisis, it had its epicenter in developed countries. Second, it is systemic, since the initial turmoil was transmitted to many markets and virtually all countries[1]. Shortly after its onset, the ongoing financial crisis has tumbled stock markets across the world and dumped other currencies against the US dollar, as investors reduce the riskiness of their portfolios and “flee to quality”, with money moving towards US assets, in particular Treasury bonds. Soon after, credit markets became blocked as banks and financial institutions were unwilling to lend to one another due to the risk of default. Following these short-run events, the crisis may damage the real economy, reducing the pace of economic growth in both developed and developing countries.

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This paper aims to describe these recent effects on emerging markets, with emphasis on the Brazilian economy, comparing the evolution of these indicators in this crisis with the Mexican and Asian crises of the 1990s. In our view, the impact of the current financial crisis on the real Brazilian economy is likely to be much less severe than during the 1990s financial crises. There are two major reasons that explain this resilience: (1) the flexible exchange rate regime; and (2) the adoption and, perhaps more importantly, the maintenance and improvement of the same set of economic policies for over a decade. The current floating exchange rates will absorb most of the shock waves caused by the crisis and channeled into the Brazilian economy though its external financial and trade linkages. Moreover, Brazilian external sustainability has been improving throughout the years due to a set of policies including higher diversification of markets for exports and increased external solvency. The remainder of the paper is divided into three sections. Section 2 presents a brief summary of the theories and empirical regularities of financial crisis. Section 3 analyses the short- and medium-term impacts of the current financial crisis with emphasis on the Brazilian economy, comparing this crisis with those that occurred during the 1990s. The last section offers some concluding remarks. 2. Theories and empirical regularities of financial crises Financial crises are not all created equal: there are at least three different types of financial crisis. The first type is the banking crisis, in which a run of depositors on the banking system leads to a systemic liquidity failure. The second type is the balance-of-payment crisis[2], in which a run on a country’s reserves leads to sudden depreciation of the national currency or foreign debt default. The third type is the asset price 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 crises Banking crises are a fairly common event in economic history[3]. In particular, crises in developing (mainly transition and emerging) economies have become an important topic in the research agenda of both academic and policymaking milieus. This is not only because such crises cause severe real economic costs and hinder development in the affected countries, but also because financial crises have become more frequent and disseminated 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 and Dybvig (1983) presented a theoretical framework for banking crises as a result of asymmetric information. If depositors’ expectations are that a bank may become insolvent, then as they rush to be the first in line to withdraw their funds, the bank will become illiquid. Moreover, if depositors interpret the run on a given bank as a signal that the whole banking system is illiquid, then a systemic banking crisis may result as sound and unsound banks cannot be discriminated. Eichengreen et al. (1998) point out other possible channels for banking crises, such as balance-of-payment crises[4] and

moral hazard stemming from guarantees such as implicit government guarantees and deposit insurance schemes. 2.2 Balance-of-payment crises Balance-of-payment crises are characterized by a run on a country’s reserves. Such episodes have been extensively studied in the literature. Although the literature refers to different theoretical models of crisis as different “generations”, we prefer to follow the simpler classification given by Eichengreen et al. (1998), who distinguished between crises caused by inconsistent policies and crises occurring in the presence of consistent policies[5]: . Balance-of-payment crises under inconsistent policies – In such models, balance-of-payment crises arise from the government objective of sustaining a fixed exchange rate while pursuing expansionary monetary policy. Free capital mobility will offset any attempt to set interest rates differently from international levels. If the government tries to pursue an independent monetary policy, then the exchange rate will be under pressure. Attempts to sustain the exchange rate will run down international reserves till the point in which the government is forced to devalue. Krugman (1979) and Flood and Garber (1984) present the seminal work on this type of crisis. . Balance-of-payment crises under consistent policies – The empirical observation that even economies with sound policies have been subject to balance-of-payment crises lead to the development of alternative models to explain such phenomena. Multiple equilibria models predict that if sustaining the parity is costly even for a well-behaved government, then there might exist an adverse equilibrium in which the optimal response of speculators is to bet against the currency and the crisis becomes self-fulfilling. Obstfeld (1986) proposes such dynamics formally. Other types of crises under consistent policies rely mostly on information asymmetry effects such as moral hazard and adverse selection[6]. The balance-of-payment crisis literature is rich and, as noted by Rodrik (1998), every new crisis in the past 20 years has spawned a whole new generation of economic models explaining the crisis that has just happened – but unable to explain or predict the next one. His conclusions are that if we are forced to look for a new series of policy errors each time a crisis hits, we should be extremely cautious about our ability to prescribe a policy regime that will sustain a stable system of capital flows. 2.3 Asset price crises An empirical observation is that financial crises often follow a period in which asset prices rise sharply and then collapse, and one may classify such crises as asset price crises[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 in credit, which may result from a policy shift from the central bank or a structural change such as financial liberalization. The increased liquidity is accompanied by an increase in assets that are in fixed supply in the short-run, typically stocks and property. The price of such assets is bid up in a spiral that can continue for some time, inflating the bubble.

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(2) Bursting the bubble – The second phase is characterized by an exogenous event that precipitates the bursting of the price bubble. It can be a change in the real economic environment such as the price of an international commodity like oil or a slump in real activity. Also, the trigger can be a shift in lender sentiment regarding the interest rate and the level of credit available in the financial system. Alternatively, changes in the political balance of power or social unrest can cause a change in investor expectations that fires an asset sell-off. (3) Ensuing financial crisis – The final phase is characterized by generalized default. Many debtors that have borrowed to buy assets at inflated prices cannot honor their obligations, compromising the soundness of the banking sector. Depending on the severity of the default, a systemic banking failure and/or a balance-of-payment crisis may follow, and the real sector of the economy is affected. Several theoretical studies have been proposed to explain bubbles. Although some approach their existence as a result of irrationality (e.g. De Long et al., 1990), a number of authors have explained bubbles as an outcome of rational behavior (e.g. Blanchard and Watson, 1982), given some market imperfection like asymmetric information. Allen and Gale (2000) propose a model in which bubbles and the ensuing financial crises are the result of the risk shifting problem between lenders and borrowers. In their 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 are particularly remarkable: (1) financial liberalization often becomes a major factor leading to such uncertainty; and (2) banking and balance-of-payment crises are often triggered by the asset price crisis. We discuss the interdependence among these three types of crises next. 2.4 “Twin” and “triplet” crises In the recent experience of international finance, many countries that have experienced a balance-of-payment crisis have also had a domestic banking crisis around the same time. This empirical regularity raised the question of the extent to which the two are linked together, hence the term “twin crises”. While theoretical and empirical work on the causes of each type of crisis generated a prolific literature[8], their interaction has been subject of less attention. In a well-known paper, Kaminsky and Reinhart (1999) draw from this literature three hypotheses concerning the chain of causation between these events: (1) Balance-of-payment crises cause banking crises – Because the government commitment to some nominal standard (i.e. the exchange rate) makes the financial sector magnify real shocks to the economy. This is so because the loss of international reserves that follows the attempt of the government to defend the currency result in a credit crunch that gives rise to increased bankruptcy in the private sector, rendering banks with a stock of non-performing loans and a full-fledged banking crisis ensues.

(2) Banking crises cause balance-of-payment crises – Because as the central bank intervenes in the banking sector to bail out troubled financial institutions, its ability to sustain the exchange rate commitment erodes. If the central bank finances the bailout by printing money, the standard first-generation model of crisis result (Krugman, 1979); if instead the central bank finances it by issuing debt, 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 – There is no reason to expect one type of crisis to anticipate the other. Since the fundamental problems are created at the same time, which crisis erupts first is a just matter of circumstance. For instance, foreign exchange rate-based stabilization plans embody the commitment of the government in sustaining some parity that restricts the role of the central bank as a lender of last resort for the domestic financial sector. At the same time, the government commitment serves as an implicit (or even explicit) guarantee that discourages borrowers to hedge their foreign currency exposure. When either type of crises erupts, it triggers the other. In their empirical investigation, Kaminsky and Reinhart (1999) indeed find that banking crises help in predicting balance-of-payment crises, but the converse is not true. However, financial liberalization helps in predicting banking crises so that rather than a causal relationship from banking to balance-of-payment crises, the evidence suggests instead that common causes characterize these events[10]. Eichengreen et al. (1998) survey the literature on the causal relationship between financial liberalization and the various types of crises and conclude that there is no definite empirical evidence that freer capital flows cause crises, although the vulnerability to previous systemic deficiencies seem to be amplified. 2.5 Economic indicators and financial crises The 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 the number of relevant economic indicators to a relatively small number. Although the consistency 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 a summarized fashion. A number of papers have embraced such task (e.g. Sachs et al., 1996; Gavin and Hausmann, 1996; Kaminsky, 1998; Eichengreen, 1999; Eichengreen and Rose, 2004, among others). In the short term, financial crises are characterized by sudden drops in the stock market, reflecting the change in economic agents’ sentiment regarding the future prospects of the afflicted economy. Risky financial assets in general lose value at the onset of a crisis, or even shortly before it, as investors reassess their expectations in light of new information or a specific triggering event[11]. Moreover, the domestic currency also loses value as international investors’ risk aversion increases during crises episodes, prompting them to rebalance their portfolios towards less risky assets, usually developed countries’ government bonds. In a financially 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 chain of events translates into a depreciation of the domestic currency in a flexible exchange rate 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 the domestic currency – which erodes the country’s foreign reserves – and/or sharp increases 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 in real activity, either by the aforementioned rise in interest rates or by a reduction in the availability of private credit due to the flight to quality of domestic investors and systemic fears of bankruptcy in the banking system. 3. Case study: Brazil and the current international financial crisis Brazil 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”) of 1994-1995 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 current international crisis. 3.1 Short-term evidence As usually occurs after the beginning of a financial crisis, stock markets tumbled around the world since last September, when the current international crisis spread in two 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 the health of large banks, after a warning that more credit-crunch related losses could lie ahead, reflecting that the crisis in the subprime mortgage lending market was leading to a more generalized credit crisis. During September, although generalized, the decline in stock markets was not so impressive, with losses in most markets not exceeding 10 percent (Table I). In October, however, in all major developed and developing countries stocks declined more significantly, as the continuous drop in stock markets across the globe also reflected dreadful economic figures, as a recession in the developed world and an economic slowdown in developing countries seemed inevitable, lowering expected profits in 2009. As a result, from early September to the end of October stock markets in Russia, Argentina and Turkey, for example, fell by more than 35 percent[14]. In developed countries the drop ranged from 26 percent in the USA to 31.6 percent in Japan. Comparing the effect in the stock market in Brazil of the current crisis with those that happen during the 1990s, one can see that the recent plunge in the stock market two months after its onset is not unprecedented. Although Brazil is one of the countries that suffered most from the subprime crisis regarding the decline in stocks, during the same 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 in capital inflows would impact Brazil to be via the stock market. Although about one-third of Brazilian shares are foreign-owned, most are still domestically held, and

Country

One-month change (%)

Russia Argentina Turkey Brazil India Indonesia Japan Canada Mexico Euro zone Thailand USA South Korea China Chile Venezuela

225.2 28.7 210.6 27.0 213.3 213.4 210.4 210.8 25.1 210.0 28.5 26.1 20.9 20.8 23.8 27.0

258.1 246.5 236.5 2 34.5 232.4 231.9 231.6 229.7 229.0 228.5 228.4 226.1 220.5 216.7 215.2 210.7

Source: The Economist (2008)

Period Brazilian Bovespa

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Table I. Stock market changes following the current subprime crisis

Mexican crisis Asian crisis Subprime crisis One-month Two-month One-month Two-month One-month Two-month change change change change change change (%) (%) (%) (%) (%) (%) 219.5

2 38.3

2 9.4

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)

consequently there will be a reduction in consumption and investment due to the wealth effect and the increased cost of capital, respectively. With regard to exchange rates, the intense demand for US assets caused a sharp appreciation of the US dollar in relation to most currencies. During the 12 months to October 2008, it is possible to note two different phases. From October 2007 to September 2008, there was a mixed picture, with some currencies showing an appreciation and others a depreciation against the US dollar. The Brazilian real, for example, registered an appreciation of about 7 percent in this period (Table III). The same phenomenon occurred with other developing countries’ currencies, for example in Argentina, Mexico and Venezuela. However, the situation changed dramatically in October, when most currencies experienced a sharp decline against the US dollar. This trend was more intense in relation to some currencies, including the Brazilian real, which showed the largest depreciation, 42 percent in that month, turning a small appreciation into a depreciation of 32 percent in the last 12 months. This recent trend in exchange rate markets occurred as the financial crisis broadened and intensified, reflecting a short-run “flight to quality” movement, usual in

Table II. Stock market changes

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Table III. Exchange rate changes against the US dollar

South Korea Brazil Chile India Mexico Turkey UK Canada Venezuela Indonesia Russia Euro zone Argentina Thailand China Japan

October 2007September 2008 (%)

September 2008October 2008 (%)

October 2007October 2008 (%)

2 25.44 1 7.22 2 4.02 2 12.98 þ 3.70 2 1.68 2 14.29 2 8.16 þ 7.80 2 1.45 2 1.20 þ 2.82 3.48 2 0.29 þ 8.92 þ 7.69

2 21.41 242.51 2 19.34 2 8.11 2 25.00 2 16.53 2 3.57 2 5.66 2 19.23 2 4.27 2 3.57 2 5.80 2 5.57 þ 0.87 þ 0.29 þ 7.41

2 52.29 232.22 2 24.14 2 22.14 2 20.37 2 18.49 2 18.37 2 14.29 2 9.93 2 5.79 2 4.82 2 2.82 2 1.90 þ 0.58 þ 9.19 þ 14.53

Notes: Exchange rate appreciation against the US dollar: + sign; exchange rate depreciation against the US dollar: 2 sign Source: The Economist (2008)

periods of economic uncertainty, as described in the previous section. Whether this situation is to be maintained remains to be seen, but its effects on the real economy are likely 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 the Mexican and Asian crises), so when the crisis began the government was forced to defend its currency by reducing foreign reserves and “dramatically” increasing interest rates, slowing down the economy[15]. Given the current floating exchange rate regime in Brazil, the sharp depreciation of the real against the US dollar will not cause such a surge in interest rates as occurred in the 1990s.

3.2 Medium-term expectations One of the most likely effects of the ongoing financial crisis is the reduction of economic growth prospects in the medium term. As mentioned earlier in this paper, financial crises contract economic activity, either through rising interest rates or by reducing the availability of private credit due to the flight to quality and systemic fears of bankruptcy. By reducing credit, the current international crisis should lead to a decrease in investment and consumption, notably in 2009. Growth expectations for 2008-2009 have already deteriorated dramatically in the last months. Most developed and emergent economies will grow less in 2009 than they did in 2007 (Table IV). While most developed countries, including the USA, The European Union and Japan, should experience a recession in 2009, some emerging economies will only experience a slowing down in economic growth. In some emerging countries, however, the expected absolute decrease in growth is significant in the period 2007-2009, especially in

Country

2007 (%)

2008 (%)a

2009 (%)a

2009/2007 change (%)

Venezuela Argentina China Brazil Euro zone Chile USA Japan India South Korea Indonesia Turkey Russia Malaysia Canada

7.9 8.3 11.5 5.4 5.4 2.6 2.1 1.9 7.9 5.0 6.2 4.9 7.2 6.0 1.7

5.2 6.0 9.8 5.2 1.2 3.6 1.6 0.7 7.7 4.4 5.8 4.5 7.5 6.0 0.8

3.0 3.5 8.5 3.4 0.6 3.6 0.6 0.6 7.1 4.2 5.5 4.3 6.8 5.6 1.4

4.9 4.8 3.0 2.0 2.0 1.8 1.5 1.3 0.8 0.8 0.7 0.6 0.4 0.4 0.3

Notes: aPredicted values Source: The Economist (2008)

Venezuela (2 4.9 percentage points), Argentina (2 4.8 percentage points) and China (23 percentage points). Although the crisis provoked an increase in the uncertainty about the impact on Brazilian growth, it is expected to reach 3.4 percent in 2009, two percentage points less than in 2007, most of this effect coming from the expected credit crunch. It is worth noting that the expansion of credit in Brazil has played a key role in increasing consumption 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 August 2008, well above the 32 percent observed one year earlier (Figure 1). Besides soaring credit, consumption has also been stimulated by falling unemployment, the increasing income of the workforce and interest rates being maintained at a relatively low level by Brazilian standards. This situation has allowed millions of Brazilians access to consumer goods, like cars, computers and TV sets, which they were unable to purchase until recently. However, the continuous increase in the base interest rate from 11.25 percent to 13.75 percent from April to September 2008 and the effects of the international crisis should change this scenario in the next months, reducing GDP growth prospects for 2009. The preceding analysis showed that the current crisis should harm the Brazilian real economy less when compared with the developed world. In the case of Brazil, its external sustainability has been improving throughout the years, as a result of many factors, including higher diversification of markets for exports, increased external solvency and the adoption of a floating exchange rate regime. The process of diversification of markets for Brazilian exports has been pursued intensively since 2002. In that year, 62 percent of Brazilian exports were destined for developed countries, while the remaining 38 percent were sent to developing countries (Figure 2). In 2007, however, developing countries were responsible for purchasing half of Brazilian exports. As the financial crisis is prone to affect developed countries more

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Table IV. GDP growth in selected countries

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Figure 1. Brazilian total credit operations (percentage of GDP)

Figure 2. Brazilian export destination countries (percent)

heavily, the increasing penetration of the country’s exports in the developing world is likely to limit the impact of the financial crisis on Brazilian exports. Moreover, the recent depreciation of the national currency against the US dollar may offset the sharp drop in commodities prices, most of them exported by Brazil. Besides the higher diversification of markets for exports, many indicators show an increase in Brazilian external solvency compared with the past. The total external debt

as a ratio of GDP, for example, declined from 41.2 percent in 2002 to 14.7 percent in 2007 (it is expected to decline further to 14 percent in 2008). This, alongside the recent increase in foreign reserves to above $US200 billion, allowed the total net external debt as a ratio to GDP became negative (2 0.9 percent) in 2007 (Figure 3). The improvement in these indicators was fundamental to allow Brazil to receive the investment grade by two independent credit rating agencies in early 2008. Furthermore, net foreign direct

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Figure 3. Brazilian total external debt (percentage of GDP)

Figure 4. Foreign direct investment £ current account ($US, billions)

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investment (FDI) is expected to reach $US35 billion in 2008, limiting the potential damage caused by the increasing current account deficit in this period (Figure 4). Finally, the current floating exchange rate regime adopted in Brazil, by reducing the effects of external crises on output, is another advantage compared with the pegged exchange rate regime implemented after the real stabilization plan in the second half of the 1990s[16]. Floating exchange rates allows the necessary adjustments via changes in the exchange rates instead of reducing foreign reserves and/or increasing interest rates as occurs with fixed or pegged exchange rate regimes. During both the Mexican and Asian crises, there was a significant increase in base interest rates in Brazil (SELIC rate[17]) in order to minimize foreign funds flowing out. Already sky-high interest rates were raised by seven percentage points to 57 percent in the aftermath of the Mexican crisis in 1995 and by an astonishing 19.5 percentage points to 40 percent following the Asian crises in 1997 (Table V). Obviously, those measures greatly slowed down GDP growth when they were implemented. In 1998, for example, while world GDP growth reached 2.8 percent, the Brazilian economy was stagnant (with GDP growth of only 0.1 percent). Therefore, given the points mentioned above, although the Brazilian economy has already been affected by the current financial crisis, through stock markets, exchange rates and credit, it seems likely that this crisis will have a much more limited impact on Brazil’s real economy than those of the 1990s. 4. Discussion and synthesis We have argued that the real consequences of the current international financial crisis in Brazil should be substantially less severe than previous crises, despite the larger magnitude of the present crisis. Why is Brazil more resilient to these episodes today than 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 improvement of the same set of economic policies for over a decade. The floating exchange rates, as illustrated above, absorbs most of the shock waves caused by the crisis and channeled into the Brazilian economy through its external financial and trade linkages. Thus, the impact of the current financial crisis on the Brazilian real economy is likely to be much less severe than during the 1990s financial crises.

Crisis period

Table V. Interest rates in Brazil before and after the 1990s crises (annual rate)

Interest rate (%) Change (%)

Mexican crisis Before After 50

57 7

Asian crisis Before

After

20.5

40 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)

Regarding the set of economic policies, president Luı´s Ina´cio Lula da Silva’s government, now in its second term in office, maintained the guidelines of the economic policy unchanged, despite sharp ideological discordances with his predecessor, former president Fernando Henrique Cardoso. In particular, president da Silva kept the floating exchange rate regime, prioritized the federal fiscal balance orthodoxy, preserved the operational independence of the central bank in setting monetary policy under an inflation-targeting regime, and stimulated the internationalization of the economy through the expansion and diversification of international trade – in particular the “South-South” trade initiative – and multinationalization of Brazilian companies. Also of particular importance in this context, we underscore the approval of Complementary Act 101 in 2000 (Brazil, 2000), legislation that established limits to the fiscal discretion of the three levels of government (federal, state and municipal). Considering the two terms that president Fernando Henrique Cardoso stayed in office from 1995 to 2002, at the end of the current term in 2010, Brazil will be under the same set of major economic policy guidelines for longer than any other period under democratic governments in its recent history. A positive effect of such stable set of policies – in conjunction with the favorable international economic environment during 2002-2007 – is the reduction of financial fragilities that had plagued the country in other periods of international financial turbulence. Therefore, given the points mentioned above, although the Brazilian economy has already been affected by the current financial crisis, through stock markets, exchange rates and credit, it sounds likely that the crisis will have a much more limited impact on Brazil’s real economy than those of the 1990s. The Brazilian experience may thus serve as a lesson to other developing countries that wish to overcome their financial fragility in an era of freer capital flows: adopt a clear, sound, and stable set of economic policies over the long term. Notes 1. The International Monetary Fund (1998) defines systemic financial crises as potentially severe disruptions of financial markets that, by impairing markets’ ability to function effectively, 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 in the service of foreign debt). However, we follow the literature and adopt the more general term 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 and Turner (1996) and Honohan (2000). 4. More on the relationship between banking and balance-of-payment crises can be found in section 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 other economies. 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, and self-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 “triplet crisis”. 10. The methodology employed by Kaminsky and Reinhart (1999) is rather unpretentious and takes into account only macroeconomic data of single countries. Certainly, there is room for improvement by employing microeconomic data such as banks’ balance sheet information and allowing for cross-country effects. 11. The triggering event could be an internal event such as a major policy change from the government, political instability in general, incapacity of the government to sustain the fiscal balance, or macroeconomic instability such as hyperinflation. Also, external events such as external changes in international liquidity, commodity price shocks that deteriorate the countries terms of trade, and contagion from crises in other countries are often listed as triggers to financial crises. 12. During the 1990s, Brazil was affected by the following major crises: Mexican (1994-1995), a domestic 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 the recent events that provoked the so-called credit crunch starting by the bailout of Fannie Mae and Freddie Mac on September 7, 2008, as the beginning of the current crisis for practical purposes. 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 in Brazil. It used the exchange rate policy, a pegged currency, subject to a gradual devaluation of about 7 percent annually, to keep inflation under control. 17. The SELIC rate is the average overnight interest rate quoted in Sistema Especial de Liquidac¸a˜o e de Custo´dia (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 Paper WP/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 and Company, Lexington, MA, pp. 295-316. Brazil (2000), “Presideˆncia da Repu´blica. Casa Civil. Subchefia para Assuntos Jurı´dicos. Lei Complementar No 101, de 4 de maio de 2000. Estabelece normas de financ¸as pu´blicas voltadas para a responsabilidade na gesta˜o fiscal e da´ outras provideˆncias”, Dia´rio Oficial da Unia˜o, Brası´lia, 5 May, p. 1. De Long, J.B., Shleifer, A., Summers, L.H. and Waldmann, R.J. (1990), “Positive feedback investment strategies and destabilizing rational speculation”, Journal of Finance, Vol. 45 No. 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 of Political Economy, Vol. 91 No. 3, pp. 401-19.

(The) Economist (2008), 25 October. Eichengreen, B. (1999), Toward a New International Financial Architecture: A Practical Post-Asia Agenda, 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 and emerging-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. and Tweedie, 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 policy options”, BIS Economic Papers No. 46, Bank for International Settlements, Basel. Honohan, P. (2000), “Banking system failures in developing and transition countries: diagnosis and prediction”, Economic Notes, Vol. 29 No. 1, pp. 83-109. International Monetary Fund (1998), “Financial crises: characteristics and indicators of vulnerability”, 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 of Governors 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 and balance-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, and Banking, Vol. 3 No. 11, pp. 311-25. Obstfeld, M. (1986), “Rational and self-fulfilling balance-of-payments crises”, The American Economic 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 lessons from 1995”, Brookings Papers on Economic Activity, Vol. 27 No. 1, pp. 147-99. About the authors Andre´ Filipe Zago de Azevedo holds a PhD in Economics (University of Sussex, UK), an MPhil in Economics (Universidade Federal do Rio Grande do Sul – UFRGS, Porto Alegre, Brazil), and a BA in Economics (UFRGS, Porto Alegre, Brazil). Currently, he is an Associate Professor of the Graduate Program in Economics at Universidade do Vale do Rio dos Sinos (UNISINOS), a Researcher 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 United Nations Conference on Trade and Development (UNCTAD). His professional and academic interests are international economics, international trade, economic development, and international 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, Porto Alegre, Brazil), and a BA in Business Administration (UFRGS, Porto Alegre, Brazil). He is an Associate Professor of the Graduate Program in Management of the School of Management (UFRGS, Porto Alegre, Brazil), Associate Researcher of E´cole des Hautes Etudes Commerciales de Montre´al (HEC-Montreal, Montreal, Canada), and Visiting Professor (Fulbright Scholar) at the University of Illinois at Urbana-Champaign (Illinois, USA). His professional and academic interests are international business, international corporate finance, international corporate governance, and international capital markets. Paulo Renato Soares Terra is the corresponding author and can be contacted at: [email protected]

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A time to return to Keynes

A time to return to Keynes

Steven Pressman Department of Economics & Finance, Monmouth University, West Long Branch, New Jersey, USA

157 Abstract Purpose – This paper seeks compare the current financial and economic problems with the problems facing the world economy in the 1930s. Design/methodology/approach – The paper argues that the Great Depression and the current problems have similar causes – excessive speculation, leading to a financial collapse that then results in an economic collapse. It then looks at the work of John Maynard Keynes to help solve the current problems. Findings – The paper advocates a large public works program plus a number of policies to help US homeowners 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 Paper type Conceptual paper

As the Great Depression swept across the world during the 1930s, John Maynard Keynes began a book he thought would transform economics. In a letter to George Bernard Shaw on January 1, 1935, Keynes wrote: “I believe myself to be writing a book on economic theory which will largely revolutionize not I suppose at once but in the course of the next ten years the way the world thinks about economic problems”. The book came out in February 1936 with an extremely intimidating title, one alluding to the revolution in physics begun by Einstein. It was called The General Theory of Employment, Interest and Money. The General Theory (Keynes, 1936), as it has come to be called, provided an analysis of how economies worked as a whole, why things could go wrong and, most important of all, it told us what to do when facing economic problems. Keynes was right. The General Theory did radically change economics. It established macroeconomics as a field within economics. In the years following the Second World War, it transformed how politicians thought about the economy and how they made policy decisions. Even President Nixon famously claimed “We are all Keynesians now”, as he employed Keynesian policies to help the US economy grow and secure his re-election. Unfortunately, as a result of the work of Milton Friedman and Robert Lucas, a backlash began in the late 1970s. This backlash picked up steam in the 1980s and early 1990s. By the turn of the twenty-first century, Keynes was largely ignored. Laissez-faire or free market economics ruled the profession and the policy-making world. One result is that we now face the possibility of another depression, brought on by another stock market crash and another credit crisis. Keynes sought to explain why the world economy found itself mired in a Great Depression and what could be done about it. The main message of The General Theory was 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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spending, jobs become plentiful and incomes rise sharply. In contrast, when firms and consumers are reluctant to spend, we face recession and depression with very high rates of unemployment. A second message of The General Theory is that capitalism requires that people take chances. But problems arise when capitalism is more about gambling than producing goods and services. As Keynes (1936, p. 159) noted, “Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done”. In the 1920s Wall Street did operate like a gambling casino. In the hope of becoming wealthy, people put little money down and borrowed a great deal of money 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 of borrowing. These gains could then be used to finance more speculation. But, like any Ponzi scheme, this required more and more money coming into the market and pushing up stock prices. The day of reckoning came in 1929 when the influx of new money slowed and some people decided to cash in their winnings. Problems became serious in October 1929 when the stock market crashed. As Keynesian economist John Kenneth Galbraith documents in The Great Crash – 1929 (Galbraith, 1954), once the market started its decline, there came the inevitable margin calls. Those who borrowed money to buy stock had to come up with more money because the value of their collateral had declined. This led to more selling, and as the market 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 speculated heavily in stocks, were in a great deal of trouble. They were facing withdrawals by depositors to meet margin calls, and they too had to meet margin calls on their stock purchases. Making things worse, with the economy slowing down, people and firms began to default on their bank loans. Under normal circumstances, when loans are repaid, the money gets lent out again as soon as possible – this is how banks make money. 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 started making withdrawals. This too was money that banks could not lend out. The result was a series of bank panics, bankruptcies, and a decade-long Great Depression. This is where Keynes comes in. The conventional wisdom at the time was the need for “sound money” and “sound finance”. Sound money meant that we could not just print up money and give it to banks to lend. Sound finance meant that the government had to keep its budget balanced. These shibboleths exacerbated the problem, as Keynes explained. Sound money meant that banks could no longer lend to businesses or to households wanting to spend but lacking ready cash. Sound finance meant that governments had to raise taxes and cut spending so that lost tax revenues due to joblessness would not result in budget 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 likely to go on a spending spree. Similarly, business firms were reluctant to expand when the demand for goods was falling. Even if they wanted to expand, they would need to borrow money. Given the problems facing banks, and their unwillingness and inability

to lend, this was not likely. That leaves the government as the only possible spender. In one of the more famous passages in The General Theory, Keynes provided specific examples of what should be done. He called for more hospitals, more schools and more roads. 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 in abandoned coalmines, and then fill the mines to the surface with rubbish. With money clearly to be made, private enterprise would dig up the notes, hire workers to help in the endeavor, and unemployment would disappear. We again face the problems of the 1930s, and we again need to heed Keynes’s advice. The balance sheets of many financial institutions are currently a shambles due to excessive speculation in mortgage-backed securities. As individuals default on their mortgages, banks cannot make new loans. And as these mortgage packages decline in value, banks lose the capital that is necessary for them to function; they teeter on the brink of bankruptcy. With credit hard to obtain, borrowing and spending fall, and the economy heads into a severe recession. In the face of these problems, stock prices tumble. Another Great Depression becomes a distinct possibility. Many financial institutions have already gone under or have been bought out by other financial institutions with government assistance. After much delay and numerous mistakes, governments throughout the world have come to realize the need to buy up these bad loans and also to provide banks with the capital that is a perquisite to making new loans. 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 does not 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 the capital banks that need, not much has changed – credit remains hard to get and stock prices have remained depressed. The problem is that lending also requires that there be someone willing to borrow and spend. As Keynes taught, if consumers and business firms are not willing to do this, the government must do it. Printing money and burying it in abandoned coalmines is a rather silly way to create jobs. It would be much better to do those things that need to be done and that would make people’s lives better. There is no shortage of what needs to be done in the USA today. Besides the crumbling roads, an insufficient supply of modern hospitals and the sad state of education, there is also a need to develop alternative energy sources to stop global warming. And as state and local budgets face massive deficits, with looming tax increases and spending cutbacks, the Federal government can provide money to lower levels of government and direct that it be spent on providing local services and maintaining public employment. Creating three million jobs at a cost of around $50,000-$60,000 apiece (pay and benefits), would cost the US government around $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 and massive consumer debt. This requires additional policy actions. First, we need to stabilize home prices. One way to do this is through tax relief to homeowners. A simple way to do this is to convert current tax deductions for mortgage interest and property taxes into refundable tax credits. At present, most middle-income homeowners get meager 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 not itemize deductions and owe little in taxes. A refundable tax credit, set near the top marginal 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 to the keep large benefits from going to wealthy Americans, we just need to cap the maximum credit available. Making this change effective January 2008 would give many middle and lower income homeowners a large tax break immediately, thus also stimulating the economy. Second, to aid homeowners we also need to do something about interest rates. Had this been 50 years ago people would have gone to their bank and negotiated a lower mortgage rate. Everyone would benefit – banks would get repaid rather than owning abandoned property, and families would be able to pay their mortgages. Today financial institutions sell individual mortgages and buy back a package containing parts of individual mortgages; unfortunately, banks cannot renegotiate the terms of what 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 that interest rate limits might be necessary. They are needed now! Despite the media hype about subprime mortgages, the real villain is the variable rate mortgage. It is not hard to understand why. People with fixed rate mortgages accepted an interest rate that enabled them to make their monthly mortgage payments. Those with variable rate mortgages were enticed by low initial payments and refinancing promises. When mortgages reset, households faced rates they could not afford; and with no equity in their homes, they could not refinance. Capping rates makes it easier for households to make their monthly mortgage payments and keep their homes. Financial institutions holding mortgage-backed securities will benefit from fewer delinquencies and foreclosures. When 30-year fixed rate mortgages are going for around 6 percent, there is a good case for capping rates at 7 or 8 percent for several years. This is much quicker and much simpler than other proposed solutions that 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 big credit crisis. Credit card debt has reached the highest level in US history, and exceeds the ability of many households to repay that debt. As lenders fear greater defaults and are less able to lend, they are making things worse by raising interest rates on credit cards. This makes it harder for consumers to spend money on new goods and services and to pay their mortgages. Part of the problem is that households can no longer eliminate their debts easily by declaring bankruptcy. Congress passed the Bankruptcy Abuse Prevention and Reform Act of 2005 after years of large financial contributions from the credit card companies. This law made it harder and more expensive for households to wipe out their debts under Chapter 7 bankruptcy. Many households must 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 a resurgence of consumer spending and little hope of a sustained recovery. There are only two ways to deal with this debt – we can force consumers to tighten their belts and pay off this debt slowly, or we can eradicate the debt quickly and give consumers the ability to spend again. Returning to pre-2005 bankruptcy laws, until a new and better law can be enacted, is thus a priority.

Finally, we need to heed Keynes’s advice about capitalism and make sure that these problems do not occur again. When we forget the lessons of history, and just think of the 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 that we need greater regulation of financial institutions. It also means severe penalties for those who promulgated the speculative frenzy – if for no other reason than to serve as a warning to those who might be inclined to take the money and run. Those pushing subprime mortgages on households because underwriting fees were greater must be prosecuted for fraud. CEOs and senior executives must also suffer great public humiliation. A strong message must go out that the gains from such activities will not be 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 author Steven Pressman is Professor of Economics & Finance at Monmouth University, Co-Editor of Review of Political Economy, and Chief Financial Officer of the Eastern Economic Association. He is the author of more than 120 articles, and author or editor of more than a dozen books, including Fifty Major Economists, 2nd ed. (Routledge, 2006). He can be contacted at: [email protected]

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International business and the crisis Jan Toporowski

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School of Oriental and African Studies, University of London, London, UK and the 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 international business. Design/methodology/approach – The paper argues that international business is differentiated by line of business and country of operation. Findings – The crisis will therefore affect international business according to how exposed such business is to international finance. Alongside the financial implications of the crisis, falling investment will reduce profits and liquidity in all business sectors. Originality/value – The most original feature of the paper is an argument that recent developments in international business have been led by financial market inflation, rather than by the autonomous managerial strategies of international businesses. Keywords Recession, Financial markets, Multinational companies Paper type Viewpoint

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It is extremely difficult to generalise about how the current financial crisis will affect international business, or multinational companies. Multinational companies tend to specialise in particular industries. All of these industries are subject to cyclical fluctuations that tend to be peculiar to each industry, although we are now about to see these cycles coincide as particular economies and regions succumb to generalised economic depression. Furthermore, multinational companies do not all operate equally across the whole world. Their operations are usually concentrated in particular regions with links to particular financial centres. While many of these financial centres are more or less affected by the financial crisis, not all regions in the world are affected by that 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 be affected in the future. Because of this differential geographical impact of the crisis, it will affect multinational companies differently according to where their operations and their financing may be concentrated. Perhaps the only generalisation that can be made about international business today is that it enters the present period of crisis and instability in remarkably good financial condition. As a result of the stock market inflation of recent years, large corporations have all raised capital in excess of their commercial or industrial requirements. Such excess capital is usually held as short-term financial assets (banks deposits, commercial paper) or else as holdings of shares in other companies. Certainly by comparison with banks in general, and many banks operating multinationally, international business has strong balance sheets and mostly good margins of solvency.

The difficulty for multinational companies is that these margins of solvency, in the form of liquid assets, will now drain away as households raise their saving rates. Fiscal deficits, which would normally increase the net income of the corporate sector, will be increasingly directed towards refinancing banking systems. Reserves, built up from capital gains on assets such as palatial headquarters buildings, will be reduced as asset prices fall. Falling fixed capital investment in the financially advanced countries, and in China, whose investment has powered the recent industrial and commodity booms of many countries, will further cut the net income of businesses. International businesses, although in a strong position in many markets, will not be able to avoid the consequences of the contraction of those markets. Postponing new investment projects will 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 to hold on to liquid assets rather than investing. But firms can only do this at the expense of other firms’ sales revenue. So, while international business is in a better position to ride out the forthcoming recession than most smaller businesses, it will also contribute more than most towards creating that recession by withholding more expenditure than most. Lakshmi Mittal may save money by cutting the capital expenditure of his international steel company Arcelor Mittal. But the suppliers of his capital equipment will lose that revenue, and those capital equipment manufacturers also use prodigious amounts of steel in their production. In any case, the rationale for investment is weak when a fall in global steel demand of 20 per cent and more is expected. A second consequence of the international financial crisis that will undoubtedly affect international business will be capital controls. It is very clear that many countries will now adopt or strengthen controls on foreign capital inflows and outflows in order to stabilise their financial systems. In the past foreign capital controls would have brought disapproval from the multilateral agencies charged with policing the international financial system – the International Monetary Fund, the World Bank, the Organisation for Economic Co-operation and Development, and behind them the USA – disapproval reinforced by the threat of exclusion from IMF-led financing. But this was because past crises were international banking crises that these agencies hoped to resolve 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 the financing requirements for alleviating the crisis. The IMF is therefore acting as a lead agency to facilitate other sources of finance. However, since the other sources have been frozen up by the crisis, an important element in the additional financing have been central bank swap facilities that have been extended by the US Federal Reserve to central banks in Mexico, Brazil, and South Korea. In Europe, the European Central Bank has extended such facilities to central banks in Hungary, the Czech Republic and other new member states. In the case of Iceland, such facilities are being provided by Scandinavian central banks. Such assistance is being targeted on particular favoured countries in difficulty. But because much of the banking systems in the beneficiary countries, in many cases most of the banking system, is multinational a more benign view is likely to be taken of capital controls. Capital controls would be necessary to prevent 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 less favoured 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 finance mergers and acquisitions in a declining capital market. It is a staple of business school research that most mergers and acquisitions do not improve the financial results of the companies being combined in this way. The rationale for mergers and acquisitions was in fact provided by capital market inflation, which made buying companies for resale at a higher price in an inflating market a profitable business proposition. This possibility no longer exists because of the large falls in the main stock markets of the world. Worse, most multinationals have their stocks quoted on more than one major stock exchange. This means that selling pressure frustrated by falling prices in one market is transmitted to other markets. Stockholders unable to sell a sufficient amount of stock in one market, because of the effect that this may have on prices, will distribute their selling across more than one market. Frustrated selling pressure will also frustrate the selling of new stock. The resulting inability to raise finance simultaneously in a number of countries will act as an informal capital control. The days of the multinational business that made money from restructuring its balance sheets in different countries is at an end. The prospects for making money in the more traditional way of production and technological innovation are not good. Inflating asset markets dominated by investment bankers earning pro rata fees for balance sheet restructuring has provided a very congenial ambience for international business theories that can provide some managerial rationale for such restructuring. Declining asset markets will be correspondingly uncongenial for such theories. Falling profits 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, financial austerity will make it much more difficult to secure financial backing for management strategies driven by speculative theoretical projections. As the present crisis reveals, financial asset inflation was the source of much of the financial success of international business and the most common means by which international business could emerge and thrive. For those researching the problems of international business, the only effective approach to understanding the subject, the crisis provides an unrivalled opportunity to uncover the true constraints that determine the character and dynamics of cross-border capitalism. About the author Jan Toporowski has worked in fund management, central banking and international banking. He teaches at the School of Oriental and African Studies, University of London, and is a Research Associate of the Research Centre for the History and methodology of Economics at the University of Amsterdam. His most recent book, Theories of Financial Disturbance, was published by Edward Elgar in 2005. He can be contacted at: [email protected]

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