Bank critics miss relative value
By Friedrich Hansen
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What if the whole point of the financial crisis is that it was to be expected on theoretical grounds? - in short, because of globalization, the superannuated "objective value theory" - price defined by Adam Smith as precipitated "work input" of any commodity - had to give way in the emerging multipolar world to the "relative, or "subjective value theory". This claims that it is basically individual human beings who make up the value of
anything in their mind - prices as flexible guesswork in a globalized world.
To put it bluntly: the whole speculative build-up of bonds resting on "securitization" of supposed fixed mortgage values might be seen as a transparent blunder.
Nevertheless, if we go by published opinion, too many people, including journalists, scientists and politicians all of whom should know better, still think that the financial crash occurred because of the failures of international investment banks. These are accused of having botched the system and with them brought down the retail banks that were attached to them and finally all our savings held by those banks.
This is why for some time the debate goes on in London and elsewhere as to whether to separate those two categories of banks. We won’t go into that debate here. However nothing could be more unwise if we consider some general arguments.
First, according to Miles Saltiel at the London-based Adam Smith Institute, it was not the investment banks that brought down the retail banks and threatened people's savings (MS, ASI report, 2011). In the United Kingdom, it was the one-time building societies like Northern Rock that failed first. After dropping their mutual status, they started offering risky mortgage deals.
Eamonn Butler told us in his ASI blog of February 4 this year: "Ultimately, it was politicians and regulators who caused the crash, by flooding the world with cheap credit and money for decades and then cutting back suddenly… No wonder banks took risks that brought them down. And when the ex-building societies were offering 120% mortgages and other risky products, the regulators did nothing" (John Redwood, Adam Smith Institute report).
Second, already two decades earlier, American mortgage lenders had been forced by the US government to offer cheap mortgages to people who basically could not afford them - only later to become known as "subprime mortgages". Since the late 1980s hundreds of thousands of those were thrown on the US housing market.
The banks, having thereby incurred a disproportionate burden of risks from subprime deals, were understandably keen to hedge those risks by repacking them in derivatives called "securities", which were sold on the international financial markets.
Tim Worstall, blogging at the ASI on February 9, argues that this "securitization" rather than hedging the risk actually encouraged further risk taking. As he explains, securitization is the "idea of chopping up a loan or a pool of loans into bonds that can then be sold off to various different groups of investors. It's often associated with structuring the pool of loans: say, one group of investors takes the first 10% of losses, the next the next 20% and so on. But this structuring isn't necessary: securitization is just the creation of the bonds that can be sold around."
Worstall points to research by the New York Federal Reserve. He tells us: "There’s ample evidence that securitization led mortgage lenders to take more risk, thereby contributing to a large increase in mortgage delinquencies during the financial crisis."
He also conducted research with Vitaly Bord suggesting "that securitization also led to riskier corporate lending." One way to do this was loosening of underwriting standards. Worstall also point out:
Finally, we find evidence that all loan investors, including banks, expect that securitized loans will perform worse. Banks appear to do so because they charge significantly higher interest rates on these loans than on the loans they don’t securitize. Institutional investors, who together with the originating bank and CLOs [chief lending officers] acquire the loans that banks securitize, follow the loan originator and choose to acquire a smaller stake in securitized loans. While on average banks retain 26 percent of each syndicated loan they originate but don’t securitize, they retain only 9 percent of each loan they do securitize...
In the last analysis, Worstall argues that we would not have had a financial crisis if the banks had not been forced to keep a percentage (usually 5%) of their own securitized loans instead of passing all those risks on to others.
If the banks had held onto zero percent of the loans that they had securitized then there would have been zero financial crisis. If all of that risk had been passed on to the insurance companies, pension funds, individual investors, then we wouldn't have had highly geared banks falling over as they had to liquidate positions in bonds fast falling towards zero.
I find this single-cause explanation insufficient. I would like to point out as additional explanation the weak fundamentals underlying the securitization. In my understanding, this is the longstanding myth that the value of commodities and assets are more or less fixed and sort of captured in those assets, rather than being naturally flexible or volatile and ultimately depending on buyers' offers.
The financial crisis came about because all those securitized mortgages couldn’t sustain the overblown derivative bonds business. Once a critical mass had accumulated, the market tipped over and turned the bond value to junk status.
What I believe was happening is this: the trust in the superannuated objective value concept collapsed. First established by Adam Smith in his Wealth of Nations - mistakenly replacing his previously held correct concept of subjective value - it is the theory that settled for the value of a thing as the representation of the amount of work necessary to produce it.
Now Lord Acton famously observed this was a forward pass for Karl Marx to expound his incorrect theory of expropriation of the workers by the capitalists - incorrect because of not accounting for the risks taken by the entrepreneur and also the cost for land, energy and infrastructure.
The Austrian School of economics spotted Marx’ mistake in timely fashion and tackled it with their theory of marginal utility, which is based on a return to the old relative value of commodities first conceptualized by the School of Salamanca in the 16th century. The late Noble Laureate Milton Friedman famously unearthed it for the US economy in the Ronald Reagan years and it served the Americans well.
Belatedly, Austrian economics is making a re-appearance in Europe too, but not on the continent, where Marx and Smith still seem to hold sway. It is on the freedom-loving green island across the Channel, drifting away inevitably by its idiosyncratic vis-a-tergo, where the Austrian School is now making advances. Just check the websites of the leading think tanks like ASI and the Institute of Economic Affairs.
But regarding the continent, we know that economic forces are stronger, at least in the long run, than the state, and will engulf and finally sink old Europe and its deep ingrained welfare state that is already subject to serious erosion. High unemployment and zero growth are the new normal in much of Europe. What after all is the euro crisis other than dwindling confidence in the objective value of its currency?
And one more point: why has all that money printing and "quantitative easing", after more than two decades starting in Japan, turned out as utterly useless? It has only prevented creative destruction or the healthy purging of our banking system as the Austrians would argue. But as currently practiced, it is, as Ellen Brown wrote on this site last month,
… simply an asset swap. The central bank swaps newly created dollars for toxic assets clogging the balance sheets of commercial banks. This ploy keeps the banks from going bankrupt, but it does nothing for the balance sheets of federal or local governments, consumers, or businesses. (Fed can fix the economy, Asia Times Online, February 27, 2013).
And she added a tip for the US:
To free the central bank from Wall Street capture, congress or the president could follow the lead of Shinzo Abe and threaten a hostile takeover of the Fed unless it directs its credit firehose into the real economy. The unlimited, near-zero-interest credit line made available to banks needs to be made available to federal and local governments.
For the time being, hold all the cash under the pillow firmly believing in the objective value concept.
Meanwhile in Europe, the tide is turning against remnants of the objective value myth, namely the one-size-fits-all austerity politics, imposed by the Eurocrats. The Italian anti-austerity vote is evidence of the crumbling of this myth. The Italians want the lira back, and other peripheral EU members are bound to follow. Germany on the other side of the crisis, in its role as the last creditor of Europe, is bracing for the worst and has begun collecting its gold deposits from Paris, London and New York that have been believed safe there since World War II.
Dr Friedrich Hansen is a physician and writer.
Speaking Freely is an Asia Times Online feature that allows guest writers to have their say. Please click here if you are interested in contributing. Articles submitted for this section allow our readers to express their opinions and do not necessarily meet the same editorial standards of Asia Times Online's regular contributors.