What Caused The Financial Crisis?

From James K. Galbraith: "There Is No Return To Self-Sustaining Growth" by Lars Schall:

The principal cause of the crisis was the dismantling of the system of regulation and supervision in the financial sector which had for much of the post-war period kept the most dangerous elements of that sector in check. In the absence of an appropriate system of effective supervision and regulation, what happens is that the actors in the system, who are intent upon taking the greatest degree of risk — including actors who are intent upon using fraudulent methods to increase their returns — come to dominate parts of the system. As they do that, the general methods of assessing performance in the market, specifically stock-market valuations, become counter-productive. That is to say, they invariably reward the worst actors, while they force more traditional actors, who are still respecting the old norms of conduct, into a competitively disadvantaged position. Thus the bad actors, the fraudulent actors, and the speculative extremists quickly take over.

Reflexivity

From The credit crunch according to Soros by Chrystia Freeland:

His core idea is “reflexivity”, which he defines as a “two-way feedback loop, between the participants’ views and the actual state of affairs. People base their decisions not on the actual situation that confronts them, but on their perception or interpretation of the situation. Their decisions make an impact on the situation and changes in the situation are liable to change their perceptions.”

It is, at its root, a case for frequent re-examination of one’s assumptions about the world and for a readiness to spot and exploit moments of cataclysmic change – those times when our perceptions of events and events themselves are likely to interact most fiercely. It is also at odds with the rational expectations economic school, which has been the prevailing orthodoxy in recent decades. That approach assumed that economic players – from people buying homes to bankers buying subprime mortgages for their portfolios – were rational actors making, in aggregate, the best choices for themselves and that free markets were effective mechanisms for balancing supply and demand, setting prices correctly and tending towards equilibrium.

The rational expectations theory has taken a beating over the past 18 months: its intellectual nadir was probably October 23 2008, when Alan Greenspan, the former Federal Reserve chairman, admitted to Congress that there was “a flaw in the model”. Soros argues that the “market fundamentalism” of Greenspan and his ilk, especially their assumption that “financial markets are self-correcting”, was an important cause of the current crisis. It befuddled policy-makers and was the intellectual basis for the “various synthetic instruments and valuation models” which contributed mightily to the crash.

By contrast, Soros sees the current crisis as a real-life illustration of reflexivity. Markets did not reflect an objective “truth”. Rather, the beliefs of market participants – that house prices would always rise, that an arcane financial instrument based on a subprime mortgage really could merit a triple-A rating – created a new reality. Ultimately, that “super-bubble” was unsustainable, hence the credit crunch of 2007 and the recession and financial crisis of 2008 and beyond.

…Soros attributes his effectiveness as an investor to his philosophical views about the contingent nature of human knowledge: “I think that my conceptual framework, which basically emphasises the importance of misconceptions, makes me extremely critical of my own decisions … I know that I am bound to be wrong, and therefore am more likely to correct my own mistakes.”

Read more here.

Trickle Up Economics

From Newsflash! Giving tax breaks to the rich doesn't create jobs, it looks like recession time, and more tales of dumb executives by Dean Baker:

Given the economy's dismal performance during the Bush presidency, a candidate who is running on the Bush economic program would have reason to be defensive, but not Sen. McCain. McCain is turning reality on its head, filling the airwaves with commercials saying that Obama's plan to raise taxes on the rich will kill jobs.

It is truly unbelievable that we are having this argument. We only have to go back to the Clinton years to see how the economy performs when tax rates on the rich are at the level proposed by Sen. Obama.

During the eight years of the Clinton administration, the private sector added 15.8 million jobs. By contrast, in the seven years and six months of the Bush administration, when rich people paid the Bush-McCain tax rates, the private sector added just 3.5 million jobs, and it is now losing jobs at the rate of almost 100,000 a month as President Bush prepares for retirement.

Read the rest here.