US financial crisis:

Some questions of ethics and law

Jayatilleke de Silva

The United States is recovering from the financial crisis that hit in 2008, it is said. The recovery, however, is said to be slow. Of course, statistics are very often dangled to prove the recovery. The public at large are yet to be assured, especially in view of the high unemployment rate which stood at 9.6 percent in October 2010, a drop of only 0.4 percent from December 2009.

The recovery is fragile, according to many economists. There is no guarantee that it would be stable. The possibility of a second crash still looms large. It would persist until and unless the root causes are identified and eliminated.

The experience of the past two years shows that apart from bailing out the banks and other financial institutions that crashed with the onset of the crisis little effort has been made to analyze and understand the root causes that caused the crisis and take remedial measures to prevent a recurrence of similar upheavals.

Academic community

There is opinion gaining ground in the United States among the academic community and the public that lack of regulation of derivatives and other modern fiscal instruments was a prime cause. It was also pointed out by several economists that the authorities had ample warnings of the impending catastrophe but they decided not to act for political or other reasons.

For example, the United States Commodity Futures Trading Commission (CFTC) Chairperson Brooksley E Born proposed in late 1990’s to regulate derivatives. It was vehemently opposed by Federal Reserve Chairman Alan Greenspan, Treasury Secretary Robert Rubin and Treasury Secretary Lawrence Summers. In 1998, the CFTC called for greater transparency of Over the Counter (OTC) derivatives. The response of the Federal Reserve System, the Treasury and the Securities Exchange Commission (SEC) was a six month moratorium on the CFTC’s ability to implement strategies outlined in its concept release policy. Further a Presidential Working Group on financial markets that helped to pass the Commodity Futures Modernization Act (2000) exempted the OTC derivatives from government oversight.

Financial system

A study done by Ross Levins for the National Bureau of Economic Research (NBER) on the US financial system published in April 2010 showed that there have been concerns expressed about the dangers of unregulated derivatives. In 1992, New York Federal Reserve Bank President Jerry Corrigan expressed grave concern that derivatives, primarily interest rate savings, threatened the stability of banks and threatened banks with tighter regulations. But Federal Reserve System Chairman Alan Greenspan supported International Swaps and Derivatives Association and successfully convinced the Congress in 1994 to keep derivatives largely unregulated.

Meanwhile, the Federal Bureau of Investigation (FBI) was worried about the fraudulent practices associated with the issuance of subprime mortgages underlying many Credit Default Swaps (CDS) securities.

In fact, fraudulent practices of financial institutions were never seriously investigated and punitive action taken. Several senior economists have commented on it.

Senior economists

Economist Max Wolff wrote in the Washington blog: “The securitization process worked by packaging, selling, repackaging and reselling mortgages making what was a small housing bubble, a gigantic one and making what became an American financial problem very much a global one by selling mortgage bundles worldwide without full disclosure of the lack of underlying assets and risks.

“Buyers accepted them in good faith, failed in their due diligence and rating agencies were negligent, even criminal, in overrating and endorsing junk assets that they knew were high-risk or toxic...The whole process was corrupt to the core”.

World Bank Chief

Prof James Galbraith was also categorical when he remarked, “you had fraud in the origination of the mortgages, fraud in the underwriting, fraud in the rating agencies”. Today not only Galbraith and several other economists but even Alan Greenspan accepts that fraud has to be dealt with. In his testimony before the Financial Crisis Inquiry Commissioner in April 2010 he said that “we will need far greater levels of enforcement against misrepresentation and fraud that has been the practice for decades”.

Nobel Laureate George Akerlof says that the failure to punish white-collar criminals - instead of bailing them out - creates incentives for more economic crises and further destruction of the economy in the future.

Another Nobel Laureate and former World Bank chief Economist Joseph Stiglitz speaking about unpunished economic criminals says, “If the legal system is seen as exploitative, then confidence in our whole system starts eroding. And that’s really the problem that’s going on.”

Prof Galbraith, however, has gone further. He questions the very economic strategies that were followed.

In his testimony before the US Senate Judiciary Committee on May 4, 2010 he said: “Economic theory, as widely taught since the 1980’s failed miserably to understand the forces behind the financial crisis. Concepts, including ‘rational expectations’, ‘market discipline’ and the ‘efficient market hypothesis’ led economists to argue that speculation would stabilize prices, that sellers would act to protect their reputations, that caveat emptor could be relied upon and that widespread fraud, therefore could not occur”. He says the financial crisis at its heart is a breached dam in the rule of law in America.

While celebrated economists are rethinking their strategies it is a tragedy that minions in developing countries including those in Sri Lanka who consider the international financial institutions as know-alls still pathetically cling on to outdated theories and practices.