Wednesday, March 16, 2011

The Myth of the "Sub Prime" Crisis

Dr. Prabhat Patnaik, Economics Professor at Jawaharlal Nehru University in New Delhi, explains how the shifting of blame to Fannie and Freddie is a myth.

The basic argument about ''sub-prime'' lending causing the crisis however was a flawed one. The banks had given loans to the so-called ''sub-prime borrowers'' against the security of the houses they had bought with these loans. If the values of the houses collapsed then banks’ asset values collapsed relative to their liabilities, precipitating a financial crisis. The cause of the crisis therefore lay not in the identity of the borrowers, the fact of their being ''sub-prime'', but in the collapse of the asset values, which in turn was because asset markets in a capitalist economy are dominated by speculators whose behaviour produces asset-price bubbles that are prone to collapse. Indeed when the banks were giving loans against houses to the so-called ''sub-prime borrowers'', they too were essentially speculating in the asset markets, using the ''sub-prime borrowers'' only as instruments, or as mere intermediaries in the process.

To attribute the crisis to sub-prime lending therefore amounted to shifting attention from the immanent nature of the system, the fact that it is characterized by asset markets, which are intrinsically prone to being dominated by speculators whose behaviour produces asset-price bubbles that necessarily must collapse, to a mere aberration, a misjudgement on the part of the financial institutions that made them lend to the ''wrong people''. It was a deft ideological manoeuvre. The identity of the people who borrowed, whether they were in rags or drove limousines, was actually irrelevant to the cause of the crisis, but it was presented as the cause. The blame for the crisis was put falsely on ''sub-prime lending''; and a fabrication, a complete myth, called the ''sub-prime crisis'' was sold to the world, quite successfully.


HispanicPundit said...

Oh okay, so its the speculators fault. I dont buy it.

Darf Ferrara said...

By provokativly labeling this post "The Myth of the "Sub Prime" Crisis" are you just trying to goad some of your readers who think that real markets might work into posting, or do you believe that Patnaik's thesis is indisputable?

I lean toward believing that sub-prime was a problem. Arnold Kling on econolog has been fairly persuasive on this. He was an economist at Freddie until the mid-90's so he has some inside knowledge of how things had worked there. And by the way, asset bubbles aren't a big problem in a capitalist system unless they are implicitly hedged against loss by the Feds.

Jon said...

The label is from the title of the article I linked to.

You say bubbles aren't a problem unless hedged by the Feds. Keynes and Patnaik say they are. It's certainly not an indisputable thesis. But it does sound plausible to me. How much of our investment pool is speculative? How rational are investors? Are they prone to euphoria? Speculators can quickly jump into an enterprise or commodity even if they don't believe the underlying assets are worth it, but merely in anticipation of other speculators jumping on the bandwagon and driving up the price. This drives actual allocation of resources. So people get in to construction and everything else. Bubble pops and the tremendous inefficiency is exposed.

That's the theory. What about the facts? You had the bubble that popped in 1929. Then after Bretton Woods you didn't have any substantial bubbles that I know of. The restraints on capital were for the very purpose of preventing bubbles. Seems to have worked. We also saw large growth and it was egalitarian world wide. The dismantling of the framework intended to prevent bubbles has been met with slower growth and unequal growth. That suggests to me that resources were allocated in a far more efficient manner during the capital restraint phase.

Darf Ferrara said...

Keynes said he was against speculators, but he made all his money by speculating. After he lost all of his money speculating, that is. He was backed by family wealth instead of the government, so he was able to get back in the game.

I won't get into how good or bad speculation is. You might agree that some level of speculation must be good, otherwise we wouldn't know how consumer preferences change. For an interesting experimental result check out this link

The issue I have with the pro-Bretton Woods position you have taken is that it assumes that the Bretton Woods could be maintained. It couldn't because of the US policy of guns and butter. Another way to say that would be to say there was a bubble in dollars. This required a huge reallocation of capital resources that was going to be painful, and restraining capital wouldn't have changed that. Not to mention, the BW required US hegemony. Why would you want to go back to a system that requires US hegemony?

Jon said...

I think Ron Paul regards the B/W breakdown as the key element leading to the decline of our economy. Here's something he wrote about it:

For example: Before the breakdown of the Bretton Woods system, CEO income was about 30 times the average worker's pay. Today, it's closer to 500 times. It's hard to explain this simply by market forces and increases in productivity. One Wall Street firm last year gave out bonuses totaling $16.5 billion. There's little evidence that this represents free market capitalism.

Haven't looked at your link yet, but will.

Darf Ferrara said...

The difference in your and Paul's understanding is that he would call the period in the decade prior to the end of BW the breakdown. Also, his solution isn't to limit the freedom of anyone, but to expand the freedom of individuals to use gold and silver as currency rather than to restrict freedoms.