Kumar David has said I have written a fairy tale when I said that the roots of the global financial crisis lay in the wrong incentives created by the U.S Governments. By giving the wrong signals to the banks and businesses, it led them to act in their perceived distorted self interest and go overboard in risk management. He cannot deny the truth of what I said. Instead he merely resorts to mocking rhetoric, characteristic of the old Marxist revolutionary who had read only the Communist Manifesto and none of Marx’s Volumes on the "Das Capital". Kumar forgets that the Marxists lost the battle of ideas some time ago. Both China and Russia are now practicing capitalism though not freedom.

Can he deny that the American government gave wrong incentives as I mentioned. Capitalism thrives on incentives and wrong incentives give wrong signals.  As Anthony De Jassy has pointed out "At least partly if not wholly as a result of stimulation by public policies favoring home ownership by very low income groups, there was much over-lending on mortgages, risky even if house prices had remained at their inflated level and loss-making if they turned down—as they duly did.

Kumar says that Freddie Mac and Fanny Mae were not government before their recent take-over. But they were government sponsored enterprises and susceptible to government influence. They were run by the Federal Housing Finance Agency, Here are their full names-Freddie Mac (Federal Home Loan Mortgage Corporation) and Fannie Mae (Federal National Mortgage Association). We know how easy it is to influence so-called government sponsored enterprises.

Loss of confidence more than loss of value

The physical capital represented by the mortgaged housing stock was not damaged, but as pointed out by De Jassy "the securities that had big batches of both prime and sub-prime mortgages as their collateral were damaged by a loss of confidence that temporarily froze them into illiquidity. There were many would-be sellers but only a few "vultures" would buy, and they only at near-absurd prices. Securities whose mortgage collateral may have become 30 per cent non-performing and that percentage, in turn, would all end in foreclosure within a year or so. No more than 50 per cent of the mortgage debt to be recovered would under these conditions have an intrinsic worth of roughly 85 per cent of their par value (a loss of 50 per cent on the 30 per cent of defaulting mortgages, i.e. a 15 per cent on all the mortgages). "But owing to the loss of confidence there were no buyers of these financial assets except at rock bottom prices such as 20% of their nominal value. (We see the same with regard to assets of the Ceylinco Group today).

As De Jassy points out "The "vultures" might buy some at 20 per cent of the nominal value which very few banks would willingly accept. However, in that case under the "mark to market" rule, ( a rule that has played its part in aggravating the crisis everywhere including our country) they had no choice but to devalue their mortgage-backed securities to 20 per cent of the par value, declaring a truly frightening loss of 80 per cent. This was the ``trigger of the panic".

All this cheap lending was made possible in the first place only because the Chinese government had been investing in American securities since they held their Official Foreign Reserves in U.S dollars. The Americans had access to a cheap source of capital from the East Asian savings which were invested in U.S Treasury securities and U.S assets. This meant that the real rate of interest and the cost of capital were cheap for American institutions. Alan Greenspan did not raise the U.S rates of interest despite the continuing deficits in the U.S balance of payments in the aftermath of the Dot.com crash.   The U.S also had no reason to depreciate the dollar and correct imbalances because there were plenty of foreign capital flows to fund the profligacy of the U.S Treasury and the adverse U.S balance of payments.

To quote De Jassy again "An exceptionally low real interest rate spectrum due primarily to the gigantic East Asian excess saving has generated a housing price bubble in the United States, Britain, Spain and Ireland. It is very doubtful whether the Federal Reserve could have resisted this even if it had wanted to." Kumar David says the same thing and hence agrees at least with this part of the ‘fairy tale’. 

What happened after that in the sequence of the financial crisis was as follows. Credit default insurance losses are a multiple of the mortgage-based losses. It was the same with other new financial products. But the magnitude of the losses became headline news and disrupted confidence further. In the words of De Jassy "at this point the effects on confidence enters the game. In particular the influence of modern, aggressive media on partly-informed opinion becomes decisive. "Things are really not too bad" is not a good headline but "things are catastrophic" is.

``In August authorities, including the head of the IMF, got into the headlines and the evening news by announcing that much, much worse is to come. Such prophecies are self-fulfilling. Even the prudent customers who have no credit card debt will stop buying durable goods, and the financial mayhem infects the "real" economy. It is a perfectly open question whether more regulation could have prevented such an outcome. Quite possibly it might have aggravated it, and may yet make any recovery slow and awkward". The banks have had to write off a few trillions of dollars from their capital.

Kumar deprecates Black and Scholes model as nothing but bourgeois contraptions of greedy capitalists. He would have us believe that all the modern financial innovations which began with Black and Scholes (Merton and Scholes received the 1997 The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for this and related work). Though ineligible for the prize because of his death in 1995, Black was mentioned as a contributor by the Swedish Academy Nobel Prize for Economics. Options and derivatives are today important financial instruments to hedge risks. It is modern financial innovations and the willingness to take risks (something which our bankers lack) and the fractional reserve banking system, that has led to the expansion of global capitalism. 

Finding Scapegoats

It is easy for politicians to put the blame on others ignoring their own lapses. Incidentally what I said about the role of the American government in bringing about the financial crisis was that it had its roots in the U.S government interferences with the market and the creation of wrong incentives. The manipulations of credit system were also inherent in creating the wrong incentives. But the crisis was too complex to be explained in terms of government wrong incentives alone. As Kumar has pointed out the cheap funds from East Asia also contributed to it as did the low interest regime of Alan Greenspan.

Kumar may give his own interpretation at the macro level by ascribing all these to the falling rate of profit. But a more optimistic Karl Marx (in Das Capital in contrast to the Communist Manifesto- a propaganda piece for revolution) anticipated the dynamics of Capitalism which has kept it going despite problems of the business cycle. There have been several business cycles since Marx’s day but the demise of Capitalism still seems premature.

People need scapegoats and the politicians need them too. Greedy bankers are easily made to fit into this role. But Capitalism or the free market economy is subject to stresses and strains and these mean the course of the capitalist economy is not smooth but uneven. As Marx correctly identified it is due to the division between the owners of capital and the workers being moved by different motivations. As De Jassy says "the trouble is that a tolerably efficient economy generates stress and cannot be purged of it without going back to quasi-medieval and quasi-Bolshevik ways (Kumar would rather do so). It is worth pausing a moment to see why this is so.

"The defining feature of capitalism is not that workers are short-changed and speculators frolic with fashion models, though such things may occur as they would in any other conceivable order (as they did in the late socialist republics, too). Instead, it is that labor and capital are contributed to productive use by two different sets of persons. Talk of harmony, co-determination and reasonableness will not alter the fact that one of the two sets of people wants a high share for labor in total factor income and the other wants a high share for capital. The resulting stress could be lifted if the provider of labor and capital were the same person. This was the case in medieval times when the artisan owned his tools, the merchant his stock-in-trade and the serf or peasant farmer his draft animal. It was also supposed to be the case in Soviet Russia and Tito’s Yugoslavia where workers were told that all capital belonged to them—a claim beneath notice. Either way, Fantasyland without capitalism would be desperately poor".

Like it or not, without strong economic growth and its inevitable disruptions, there is little hope for creating the healthy middle classes necessary to sustain democracies, much less an improvement in the lot of the poor and dispossessed.