Economist Stiglitz Condemns Moral Deprivation in Ersatz Capitalism
Henry C.K. Liu

This article appeared in AToL on January 26, 2010

Nobel Laureate economist Joseph Stiglitz, a Roosevelt Institute Senior Fellow and its Chief Economist, said on CNBC on January 19, 2010 that the US is infested with “ersatz capitalism,” a flawed, unfair system that socializes economic losses and privatizes the gains.  He decries the “moral depravity” that has led to the current financial crisis.
Stiglitz served as the Clinton administration’s Chairman of the Council of Economic Advisers (1995-97) before moving to the World Bank as its Chief Economist, where he experienced a Pauline epiphany against the very neo-liberalism he had helped promote in the form of “the Third Way”, to criticize belatedly but rightly and vocally IMF policies. Such outbursts put him in conflict with the Treasury Department under Larry Summers who reportedly forced Stiglitz to resign (2000), presumably for not being a team player. Notwithstanding his government career setback, Stiglitz was selected as a recipient of the 2001 Nobel Prize for Economics.
Despite heavy pressure from the Treasury to silent him, Stiglitz has been the courageous voice of progressive economics, criticizing the structural defects of central banking, deregulated free market fundamentalism and predatory globalization. Stiglitz is now a University Professor at Columbia and one of the most respected and cited economists in the world as a courageous defender of the defenseless.
As Professor Stiglitz knows, the “moral depravity” he so detests about the current financial crisis began much earlier.
I wrote in AToL on May 23, 2002 - The Dangers of Derivatives:
The financial crises faced by newly industrialized economies (NIEs) in the 1990s were significantly different from the foreign debt crises in the developing countries in the previous decade. Different forms of foreign funds flowed to different recipients in developing countries during the two periods. More importantly, derivatives emerged as an integral part of fund flows in the 1990s.

Derivatives played an unprecedented key role in the Asian financial crisis of 1997, alongside the growth of fund flows to Asian NIEs, as part of financial globalization in unregulated global foreign exchange, capital and debt markets. Derivatives facilitate the growth in private fund flows by unbundling the risks associated with financial vehicles, such as bank loans, stocks, bonds and direct physical investment, and reallocating the risks more efficiently by expanding the distribution and the level of aggregate risk. They also facilitate efforts by many financial entities to raise their risk-to-capital ratios to dodge regulatory safeguards, manipulate accounting rules and evade taxation. Foreign exchange forwards and swaps are used to hedge against floating exchange rates as well as to speculate on fixed exchange rate vulnerability, while total return swaps (TRS) are used to capture "carry trade" profit from interest rate differential between pegged currencies.

Structured notes, also known as hybrid instruments, which are the combination of a credit market instrument, such as a bond or note, with a derivative such as an option or futures-like contract, are used to circumvent accounting rules and prudential regulations in order to offer investors higher, though riskier, returns. Viewed at the macroeconomic level, derivatives first make the economy more susceptible to financial crisis and then quicken and deepen the downturn once the crisis begins. Since investors can only be seduced to higher risk by raising the return on higher risk, the quest for high return raises the aggregate risk in the financial system. But investors always demand a profit above their risk exposure which will leave some residual risk unfunded in the financial system. It is in fact a socialization of unfunded risk with a privatization of the incremental commensurate returns.

The private global fund flows that led up to the crises of the 1980s were largely in the form of dollar denominated, variable interest rate, syndicated commercial bank loans to sovereign borrowers, recycling petro-dollar deposits from OPEC trade surpluses. The formation of syndicates to underwrite these loans helped to bind lenders together, and along with cross-default clauses in the loan contracts, it greatly reduced individual banks’ credit risks by passing such risk to the banking system. Loan syndication amounted to a lender monopoly with open price-fixing between previously competing banks.

In order to reduce the banks’ collective exposure to market risk, these loans were issued as adjustable interest rate loans (usually priced as a spread above LIBOR or some short-term interest rate that reflected banks’ funding costs), and they were denominated mostly in dollars or otherwise in other G-5 currencies (which reflected the currency denomination of the lending banks’ funding sources). Foreign fund flows in this form shifted most of the market risk to the borrowers who might not have fully understood that they bore both foreign exchange risk as well as interest rate risk, and the spiraling exacerbating effect of the two risks on each other, i.e., rising dollar interest rates would devalue non-dollar local currencies which in turn would push up local interest rates.

Lending banks in the advanced financial markets of the 1980s, whose liabilities were mostly short-term and denominated in the same currencies as their loans to developing countries, bore little market risk. Their exposure was almost entirely credit risk, and this was substantially mitigated through the syndication of the loans and the inclusion of cross default clauses. Thus a supposedly “free” debt market transformed itself into a bilateral market between powerless individual borrowers and an all-powerful lending monopoly. It was the height of hypocrisy that in an era of blatant financial monopoly that neo-liberal finance market fundamentalism achieved its unprecedented intellectual ascendancy.

The change in the distribution of market risk to Third World sovereign borrowers laid the foundation for the crisis that began in August of 1982. The crisis began when the Federal Reserve raised short-term dollar interest rates to fight US run-away stagflation. Higher dollar interest rates, which served as the basis for payments on adjustable rate loans, both increased the dollar payments on loans and increased the cost in non-dollar local currencies for dollars. Debtor countries were forced to drastically increase their foreign borrowing in order to reduce the burden of servicing suddenly higher foreign debt costs, leading to inevitable crisis.

In August of 1982, the Mexican government announced its inability to make scheduled foreign loan payments. In response, the developing economy governments, major money center banks, and the IMF and World Bank began searching desperately for post-crisis recovery policies, initially by rescheduling existing debt, arranging new lending and requiring the developing economy governments to implement austere fiscal and monetary policies to make possible the eventual repayment of the continuously growing debt burden, but in effect foreclosing developing economies any prospect of growth with which to repay the still mounting foreign loans. The foreign creditors were protected; the debtor developing nations lost what little they had gained in the previous decade and then some, with no prospect of ever escaping from the tyranny of foreign debt in the foreseeable future. Neo-liberal economists cited Shakespeare: Better to have loved and lost, then not to have loved at all, while their paying clients laughed all the way to the bank.

The Asian financial crises that began in 1997 were very different phenomena. They were caused by hot money (short-term foreign credit based on over-valued exchange rates that were defended beyond reason by Third World monetary authorities poisoned by neo-liberal advice). Derivatives trading in over-the-counter (OTC) markets were, and still are, neither registered nor systematically reported to the market. Thus the full risk exposure in the system is not known until the crisis hits. In macroeconomic terms, derivatives have the structural effect of privatizing the incremental efficiency (profits) while socializing the risk (losses) associated with such profits. This is done by extracting value through rising risk/return ratios by siphoning off part of the incremental return to known private parties while passing on the full incremental risk to faceless third parties spread throughout the system. Since the spread was minuscule, profit incentive pushed for massive increases in volume.

The foreign private fund flows that preceded the 1997 financial crises went to private entities in Asia and not just to sovereign borrowers as in the 1980s. Commercial bank loans in the 1990s, measured as a percentage of total foreign fund flows, were substantially less important than they were in the 1980s. Instead, fund flows to Asia ranged from foreign direct investment (FDI) to portfolio equity investment (meaning less than 10 percent ownership), corporate and sovereign bonds as well as structured notes, repurchase agreements, on top of traditional bank loans to public and private borrowers. This more diversified flow of funds generated a different distribution of risks towards global institutional investors, mainly pension funds in the advanced capital and debt markets. Stocks and bonds investments in Asia shifted market risk and credit risk to foreign institution investors who bore the risk of changes in interest rates, securities prices and exchange rates.

FDI in physical capital and real estate similarly shifted market risk and credit risk to foreign institutional investors. Even dollar denominated bonds issued by Asian governments shifted interest rate risk, as well as credit risk, to foreign institution investors. Socialized finance in the rich economies, what the Wall Street Journal fondly referred to as mass capitalism, was called on to finance old-fashioned compradore capitalism in the NIEs. The effect was to expose the NIEs to the risk of changes in US interest rates or the exchange value of the dollar, not as economic fundamentals, but as technical trends perceived by the herd instincts of fund managers in the advanced markets. Thus the neo-liberal focus on the need to resolve the national banks’ domestic non-performing loans (NPL) as a prerequisite for generating growth is, to say the least, misplaced. The NPL problem in Asia is a fiction invented by the Bank of International Settlement (BIS) to prepare national private banks as ripe targets for predatory acquisition by Western large, complex banking organizations (LCBO).
Today, as predatory capitalism hits its own home base, it is possible that a new world economic order will soon emerge from people power. Unfortunately, all governments are still fixated on “recovery” schemes concocted to turn the crisis back to the very same flawed system of moral depravity that had led the world to its present disastrous state. Much of the talk now among establishment economists has been focused on technical debate on the government stimulus packages being too small to kick-start the seriously impaired economies around the world, when the problem has been that good public money has been targeted for bailing out undeserving private institutions to enable them to again play the same immoral game of reckless speculation through “carry trade”, risking the people’s money for unproductive, obscene private profit, while leaving a dispirited population unemployed and underemployed, with families with young children facing homelessness. If even only a fraction of the people’s money is spent directly on the people themselves, the world will emerge with a new economic order of moral justice instead of deprivation.
Ron Paul, Republican congressman from Texas, told Federal Reserve Chairman Bernanke in a hearing that the Federal Reserve is a “predatory lender”. But he did not mention that by law, predatory lenders forfeit any right of collection.
In the United States, although predatory lending is not defined by federal law, and various states define abusive lending differently, it usually involves practices that strip equity away from a homeowner, or equity from a company, or condemn the debtor into perpetual indenture. Predatory or abusive lending practices can include making a loan to a borrower without regard to the borrower's ability to repay, repeatedly refinancing a loan within a short period of time and charging high points and fees with each refinance, charging excessive rates and fees to a borrower who qualifies for lower rates and/or fees offered by the lender, or imposing new unjustifiably harsh terms for rolling over existing debt. Predation breaks the links between an economy’s aggregate resource endowment and aggregate consumption and between the interpersonal distribution of endowments and the interpersonal distribution of consumption.

The choice by some to be predators decreases aggregate consumption, both because the predators’ resources are wasted and because producers sacrifice production by allocating resources to guarding against predators. Much of welfare economics is based on the concept of Pareto Optimum, which asserts that resources are optimally distributed when an individual cannot move into a better position without putting someone else into a worse position. In an unjust global society, the Pareto Optimum will perpetuate injustice.

Why isn’t the legal concept of lender liability applied to stop foreclosure of homes with young children?  In the US, lender liability is embodied in common and statutory law covering a broad spectrum of claims surrounding predatory lending. If a lender knowingly lends to a borrower who is obviously unable to make reasonable beneficial gain from the use of the funds, or causes the borrower to assume responsibilities that are obviously beyond the borrower's capacity, the lender not only risks losing the loan without recourse but is also liable for the financial damage to the borrower caused by such loans. For example, if a bank lends to a trust client who is a minor, or someone who had no business experience, to start a risky business that resulted in the loss not only of the loan but also the client trust account, the bank may well be required by the court to make whole the client.

The argument for home mortgage debt forgiveness contains large measures of concepts of lender liability and predatory lending. Debt securitization allows predatory bankers to pass the risk to global credit markets, socializing the potential damage after skimming off the privatized profits. The housing bubble has been created largely by predatory lending without any lender liability. The argument for forgiving defaulted home mortgage debt is applicable to low- and moderate-income home mortgage borrowers in the US as well.  Progressives should push for proactive commitments from both political parties instead of empty populist moralizing.
January 21, 2010