Monday, October 8, 2012


"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 (Steve 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. This article looks at the political and cultural determinants of the current crisis, using three intertwined themes:

(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.

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.

Whether we're talking about democracy underpinned by law or constitutional framework, the liberal democracies of Western Europe or the constitutional democracy of the USA, democracies work on the basis of the refreshing and realistic precept of the inevitability of human frailty 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 characterised by endless subversion, thwarted and side-stepped by constant attempts from within and without to turn its frail authority into forms of power to be used against it.

Democracy by its very nature 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 beliefs 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 belief systems 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 a market fantasist belief, 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 a core belief directly contradicting the central precept of democracy discussed above it represents the idea that the unheeding self-interest of billions (in reality, of course, no more than a few thousand elite worldwide) acting together will lead to a universally prosperous and orderly society. In the 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 a 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, "truth-giving' 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 delusional 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 dictated by that core discourse. Since the turf fights between Islamic and Christian belief systems from the seventh century onwards, few core belief systems 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 universal modern religion; a core belief system that is still just a belief system, but which has overcome the traditional limitations of religion by asserting the coloration of scientific inevitability 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).

Whilst the Socialist Bloc existed, the governments of liberal Western democracies needed to be politically restrained in their approach to market freedom; the threat of an alternative belief-system existed (however imperfect) and the governments of the Western Bloc had to exert caution over permissible amounts of volatility and instability (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 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 probable that Western liberal democracy would succumb to the global advance of Soviet Socialism, increasing confidence in the supremacy of globalising capitalism overthrew any perceived need for regulatory caution, especially during monetarist regimes of Margaret Thatcher in the UK and Ronald Reagan in the USA. The terminal decline of the Socialist Bloc 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 to feed the voracious demand for capital fuelling the non-inflationary continuous expansion (NICE) era of the 1990s. 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; 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, as having an essential flaw.

This "coming of age" of the market was accompanied by an acceleration of the amount of money invested in this market. 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. Financial derivatives became somehow synonymous with the buzzword "globalisation" exotic, powerful and barely understood even by the most unquestioning fans. 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 accepted as an accurate measure of credit quality.

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 over state-channelled democratic oversight the markets were themselves become democracy in action.

At the same time 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 Bank of International Settlements estimates for the total monitored trade in derivatives some $680,290,700,000,000 for 2007-2008.

Continuing faith in market fundamentalism, however, means that 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 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 purports to be 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)."

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 taking 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)."

The development of financial derivatives throughout the period since the 1970s 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 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".

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 obscure equations to detach the element of risk on bundles of sub-prime 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) 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.

Quis custodiet ipsos custodes?

"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)."

Concealed by the market-fundamentalist beliefs discussed above there is another interesting and powerful socio-political theme of really-existing globalization. This is the effective development over the last three decades of a supra-politics of hyper-accountancy, the massive increase in growth and concentration of power in the accountancy sector 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 power 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 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 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 conflicts of interest 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 and thus shopped around more for the best deal; and secondly, because of the 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", 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 (for instance 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 consultancy, in order to pursue non-audit profitability.

Whilst this may have been logical, it of course represented an even starker conflict of interest; 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 conflict of interest could be produced, then none existed.

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 conflicts of interest 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 interest conflicts. 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.

In general terms auditing services provided by firms of accountants have been consistently promoted as a technology for the management of risk, 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 Ernst & Young themselves 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)"

By 2008, however, during the first financial crisis to occur under a predominantly fair value regime, opinions seemed to have changed. PricewaterhouseCoopers for instance 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 reports current market values".

According to PWC 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 sub-prime 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)".

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. 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) inevitable. 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 shadow markets which guaranteed disaster.

It is also highly unlikely that an 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. 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 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 pessimists 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.

The consequences 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 multi-national or supranational institution need depend on something as boring and irritating as mere democracy. Instead, politician, minister, president, accountant and CEO alike, all will take deep breaths, close their eyes and believe six impossible things before breakfast.