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Did Capitalism Fail?

The Financial Crisis Five Years On Roman Frydman Professor of Economics, New York University Founding Editor and Director, Project Syndicate The Keynote Address to the European Financial Congress Sopot, Poland, 24-26 June, 2013

Good evening, Distinguished Guests, Ladies and Gentlemen. I am deeply honored to address this important gathering. I would like to begin by thanking Professor Pawlowicz for inviting me here, and for his initiative and support in launching Project Syndicate Polska at this Congress. My long time friend, the brilliant Lejb Fogelman, conceived of Project Syndicate Polska. He realized distinguished international voices, including Project Syndicates great friend, Joshka Fischer, who is with us tonight, can add an important aspect to the debate in Poland concerning key economic, political and social issues. Project Syndicates network of nearly 500 media organizations in over 150 countries can also provide a unique platform for Polish intellectuals, business leaders and policymakers to reach the public in Europe and around the world. Lejb, Tomasz Misiak, Ireneusz Piecuch, and Michal Kobosko have worked tirelessly in getting Project Syndicate Polska organized and funded by many enlightened and far-sighted Polish companies and individuals. The amazing speed with which they managed to create and launch this initiative provides yet more evidence of the extraordinary entrepreneurial energy and creativity in Poland forces that can be mobilized only if government policymakers adopt a pragmatic approach, like that demonstrated in recent years. Such official openness to new ideas has clearly underpinned the countrys remarkable economic and political success. In thinking about the theme of tonights address, I was guided by the Congresss main objective: to identify the most recent challenges posed by the contemporary economy [and] present suggestions for their solution. As many of these challenges stem in one way or another from the global financial crisis, I thought that the upcoming fifth anniversary of the collapse of Lehman Brothers, which many regard as marking the onset of the crisis, provides an ideal vintage point for broader reflection. What we consider a solution to the challenges that we face crucially depends on the conceptual framework that we use to understand the economy, and more broadly, society at large. As my mentor and friend, Edmund Phelps, is fond of saying, there is nothing as practical as a good theory. John Maynard Keynes reached a similar conclusion, but from a different angle. As he famously put it, the ideas of economists, both when they are right or wrong, are more powerful than is commonly understood. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.
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So you may have already guessed the main thesis of my talk. I do not think that the financial crisis should be viewed as the failure of capitalism. Instead, I would like to pin a significant share of the blame on economists. It was their ideas concerning the role and functioning of financial markets in capitalist economies that provided the supposedly scientific underpinning for policy decisions and financial innovations that made the crisis much more likely, if not inevitable. As former Federal Reserve Chairman Alan Greenspan stressed in his testimony before the US Congress a month after the Lehman collapse, self-interest had failed spectacularly in protecting society from the financial systems gross excesses, culminating in the worst crisis since the Great Depression. Greenspan admitted that he had found a flaw in the ideology that unfettered financial markets would limit their own excesses. My main point is that the flawed ideology that Greenspan was pointing to can be traced directly to the fundamental flaws in the economic and finance theories, which have held sway for decades, concerning the causes and key role of financial-market instability in capitalist economies. Of course economists recognize that assets that trade freely in financial markets have a tendency to undergo fluctuations away from and toward benchmark levels. But prevailing economic and finance theory attempts to account for such swings by presupposing that market participants and policy officials never search for genuinely new ways of using their resources and never revise the way they that think about the future. As a result, the prevailing models account for risk and fluctuations in asset prices as if the future mechanically followed from the past. No doubt, economists need to make some assumptions as they build their models. But economists model-building is not some harmless academic exercise. These models wield significant influence over real financial-market participants, policymakers, and the wider public. The assumption that the movements of asset prices and risk follow mechanical rules underpinned the creation of synthetic financial instruments and legitimized, on supposedly scientific grounds, their marketing to pension funds and other financial institutions around the world. Remarkably, countries that have relatively less developed financial markets and have not yet adopted such innovations escaped many of the more egregious consequences of the proliferation of synthetic instruments.
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As observers have remarked, Poland belongs to this group of lucky laggards. As this Congress considers solutions to the problems that Poland and Europe face, it is important to keep in mind the unsuccessful and largely American experiment in viewing the macroeconomy and financial markets as machines, market participants as robots, and economists and finance practitioners as engineers designing the participants interactions. But perhaps the most misleading implication of these mechanistic models concerns their claims about the role and function of financial markets and the reasons for their inherent instability. Mechanistic models imply two extreme views: either financial markets are nearly perfect at allocating societys capital, or they are irrational, casino-like institutions that allocate capital haphazardly. Such extreme views have not only shaped thinking about financial reform, but have also profoundly affected the publics attitudes toward the role of the financial system in modern economies, and about the future of capitalism. The rational market view, which has been ascendant for almost four decades, asserts that markets allocate capital nearly perfectly, because they are populated by the so-called rational individuals who supposedly have the ability to ascertain exactly the true prospects of projects and companies. According to this view, even if the upswing in asset prices reaches levels that virtually all observers, including market participants, consider excessive, the state has no reason to dampen such instability. The role of the state should be strictly limited to providing the basic framework for the operation of competitive financial markets. Unfortunately, many officials worldwide came to embrace this belief, resulting in the massive wave of deregulation that emerged in the 1980s and accelerated in the late 1990s and early 2000s. Official faith in the mechanistic rational market also encouraged governments to turn a blind eye to the dramatic upswings in housing, equity, and other asset prices that occurred in the run-up to the crisis. As Greenspan acknowledged, self-interest could not be counted on to dampen excessive price swings. Markets eventually did start to self-correct, but they did so too late. As we learned from the crisis, an excessive run-up in asset-prices exposes the banking system and financial markets to enormous risks and eventually leads to the danger of financial implosion, followed by painful shifts in consumption and investment patterns, a prolonged downturn, and sharply higher unemployment.

Since this Congress focuses on practical problems, it might be worthwhile to take another look at the much-talked-about failure of major rating agencies to issue precrisis warnings of the impending collapse of major financial institutions. Lehman Brothers Holdings declared bankruptcy on September 18, 2008. Yet Standard & Poors maintained its solid investment grade of A for Lehman until just six days earlier, when it abruptly downgraded the firm to Selective Default. Moodys waited even longer, downgrading Lehman one business day before it collapsed. How could the most reputable ratings agencies and an investment bank so experienced in issuing securities end up looking so bad? Much attention has been focused on predatory practices in originating mortgages, and on the cozy relationship between investment banks and the rating agencies entrusted to rate their structured assets. These, no doubt, are important defects that were largely ignored. But there is a more basic cause: the agencies procedures for rating assets have not allowed for the potential severity of reversals following dramatic upswings in asset prices. Even if the agencies relied solely on state-of-the-art practices, rather than following their narrow commercial interests, their ratings would have significantly underestimated the risk of the securities that they rated. This underestimation would have occurred because the statistical models on which they rely projected historical default patterns into the future. These patterns showed very low loss rates, owing to ever-rising house prices. With low loss rates, AAA ratings appeared to be justified. The longer the boom lasted, the more the ratings agencies trumpeted the superiority of structured finance over loans to businesses, and the more investors came to rely on these ratings. It was like a hall of mirrors. But the truth is, as we all know, in capitalist economies, future market outcomes do not mechanically follow the past. Indeed, failed attempts to find empirically relevant mechanical models that relate asset prices to fundamental macroeconomic variables, such as company earnings and interest rates, have persuaded many academic economists that the fluctuations of asset prices and risk are unrelated to economic fundamentals. These so-called behavioral economists advanced the other extreme view of financial markets. They regarded asset-price swings as bubbles that are driven by psychological factors and market participants irrationality. In turn, viewing markets as casino-like institutions implied that asset-price fluctuations are
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associated with misallocation of societys savings. The state should thus use all powers at its disposal to prick such bubbles as soon as they arise. It is difficult to imagine two views of markets more further apart. For one camp, markets are rational, allocate capital nearly perfectly, and require only a narrowly delimited role for the state. For the other, markets are grossly inefficient, prone to bubbles, and call for an extremely powerful role for the state. But for all their profound differences, these extreme positions share the same fatal flaw: the core belief that economic and political change that no one not market participants and not economists can fully foresee is unimportant for understanding market prices and risk. Paradoxically, bubble models, which were supposed to undermine the belief that the market allocates resources nearly perfectly, ended up reinforcing the markets mythic significance. If only informational distortions and deficiencies in market competition were minimized, psychology eliminated from individual decisionmaking, and irrational speculators banned from influencing outcomes, rational participants would regain the upper hand, and the market would supposedly again set prices at nearly true fundamental values. This way of thinking reminds me of the old joke about communism: it would work perfectly, if not for the people. The markets potential to allocate resources nearly perfectly is, in fact, a myth in the strict sense of the word: it is, as the Oxford English Dictionary puts it, a widely held but false belief. It cannot be turned into reality by any means, including regulatory policy. The reason, again, is simple: the underlying values of assets unfold over time in ways that no one can fully foresee. In principle, there can be no true values of assets that competition among rational participants could possibly establish. I remember quite vividly -- becoming aware that there was something wrong with such models when I entered graduate school in economics at Columbia University in New York in the 1970s. Having recently arrived from Poland, the idea of market perfection sounded very much like some central planners platonic ideal. Only later did it become clear to me that the prevailing macroeconomics and finance models that were advanced by Chicago School theorists and adopted by their Keynesian counterparts at MIT bear an uncanny resemblance to the planning models advanced by their leading theoretician, Oskar Lange. Lange, it so happened, spent a lot of time at Chicago studying mechanistic models of capitalist economies.
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Reading Friedrich Hayeks critique of Lange, I realized that, despite Hayeks and Keyness very different ideological positions on the market-state balance, they had this in common: both placed non-routine change and the imperfect knowledge that it engenders at the center of their accounts of economic outcomes and of their thinking about the rationale and scope of public policy. Of course, I do not need to dwell at a gathering of distinguished finance professionals on the fact that in the vast majority of cases, the prospects of an investment project can be known only imperfectly, which in turn gives rise to financial markets essential role. These markets translate individuals myriad bundles of knowledge and intuition about projects and companies into prices of equities and other financial claims. As market prices unfold over time, they provide a better assessment of the changing values of alternative investment projects than any estimate of those values that an individual could ever produce on his or her own. But, even though financial markets are the best institution available to help society allocate its savings, the very reasons that they are essential to modern economies non-routine change and ever-imperfect knowledge also make them imperfect assessors of asset values. As a result, they do not allocate capital perfectly, even when functioning normally. Recognition of market participants ever-imperfect knowledge has important implications for our understanding of financial markets instability and financial risk. Asset-price swings arise as market participants attempt to cope with their ever-imperfect knowledge of the future stream of profits from alternative investment projects. Financial market instability is thus integral to how capitalist economies allocate their savings. The need for state intervention in asset markets arises not from policy officials superior knowledge about asset values, but because profit-seeking market participants do not internalize the huge social costs associated with excessive upswings and downswings in these markets. Thus, recognition of imperfect knowledge goes a long way toward explaining what partly troubled Greenspan: why self-interest failed to protect society from excessive asset-price swings. Society has an interest in instituting a policy framework that dampens such excessive swings and regulates financial institutions exposure to them before they reach crisis levels. The Imperfect Knowledge Economics framework that Michael Goldberg and I proposed points toward a new way of addressing both of these objectives.

Because mechanistic models, such as widely used approaches based on value-atrisk calculations, relate financial risk to the volatility of asset prices over a month or a quarter, rather than to how far prices have moved in one direction or another, they obscure the inherent connection between financial risk and long swings in asset prices. By contrast, Imperfect Knowledge Economics relates risk to participants perceptions of the gap between an asset price and its range of historical benchmark levels: as asset prices rise well above or fall well below most participants perceptions of these levels, those who are betting on further movement away from the benchmark should perceive an increased risk in doing so. An Imperfect Knowledge Economics account of risk in financial markets suggests that excessive overall price swings in equity and housing markets, as well as in the key sectors to which banks loan portfolios or trading books are heavily exposed, provide complementary indicators of risk both for individual banks and for the system as a whole. Dynamically relating banks capital buffers to these indicators would provide regulators with an additional tool for managing systemic risk. But regulation best protects banks and the broader economy from the consequences of sharp reversals in asset prices by targeting excessive asset-price swings directly. The policy framework suggested by Imperfect Knowledge Economics aims to weaken market participants incentives to prolong price swings beyond levels that are consistent with their own assessments of the longer-term prospects of projects and companies. The inherent connection between asset-price swings and the process by which financial markets allocate capital suggests that prudential state intervention should not aim to eliminate market instability. Cutting off price swings early is likely to impede innovation, thereby reducing the economys dynamism and growth potential. Consequently, the Imperfect Knowledge Economics -based policy framework occupies an intermediate, pragmatic position between the two extremes implied by mechanistic models: it neither supposes that the state should never intervene in financial markets, nor calls for massive intervention to eliminate asset-price swings. So long as asset-price fluctuations remain within reasonable bounds, the states involvement should be limited to setting and enforcing the rules of the game: ensuring transparency and adequate competition, and eliminating other market distortions (such as those exposed by the crisis). But policymakers should also devise guidance ranges for asset prices. In doing so, they should not rely solely on
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historically-based valuations, which, because they ignore non-routine change, are unreliable as a guide to likely thresholds of excess during asset-price swings. Once prices move beyond such a guidance range, Imperfect Knowledge Economics suggests that policy officials should cautiously and gradually implement dampening measures, as well as require banks to prepare for the eventual reversal by increasing their loan-loss provisions. Although I am not an expert in Polish economic developments in recent years, it seems to me that policymakers actions in the foreign exchange market have been consistent with such a pragmatic policy framework. For example, as widely reported in the press, the Polish National Bank intervened on Friday, June 7, to dampen a sharp downswing in the zloty-euro exchange rate. Our proposed regulatory framework recognizes that policy officials, like everyone else, must cope with ever-imperfect knowledge. Indeed, the inherent limitation of what we can know about the future underpins our rationale for active prudential intervention, which is now very much on the agenda of financial reform in Poland and Europe. It also points to practical tools to implement such a prudential framework. It is my hope that the Imperfect Knowledge Economics-based policy framework, which rejects both of the ideological extremes implied by prevailing macroeconomics and finance theory, will help to restore some much-needed balance to the public debate concerning what should be left to the market and what only the state and collective action can accomplish.

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