Structural Causes to the Financial Crisis and their Discontents

James Crotty has argued that the crisis of 2007-8 was cause by structural issues in the economy, mainly derived from the deregulation in financial markets that came into being during the Reagan and Thatcher years which were given rhetorical firepower and ideological backing from economics theorists like Milton Friedman and Eugene Fama.  In both “The Realism of Assumptions Does Matter: Why Keynes-Minsky Theory Must Replace Efficient Market Theory as the Guide to Financial Regulation Policy” (2011) and Crotty an earlier 2008 paper,  “Structural Causes of the Global Financial Crisis: A Critical Assessment of the ‘New Financial Architecture,” Crotty develops these arguments. In 2008, Crotty wrote “Central banks and other regulatory bodies will be forced to take whatever interventions are required to stop the financial and possible economic collapse – no matter how high the cost” (53). In the next sentence he says, “the dynamic of deregulation leading to financial booms that eventuate in crisis that lead to bailouts and thus to yet larger booms roll on.” Here we find the root of the argument that he makes in the papers. The ideology surrounding finance is such that architecture leads to people working in the margins, doing what they can to generate more cash for themselves. And then periodically it will blow up. The playbook then is not to use the crisis as an impetus to reform the system, but instead to shovel more money at the very system that just failed in order to paper over the real problems and to let the rot continue. 

Crotty calls this structural rot the “New Financial Architecture” or the “NFA”. Under the NFA, what we have is a system of banks and other financial institutions such as Hedge funds, special investment vehicles that operate under light regulation or no regulation at all. Crotty argues that this arrangement persists because of the theory of efficient markets. Economists and financial professionals have pushed the idea that the best regulatory intervention in the financial market is no regulation at all. A truly efficient market works out the kinks itself through the assumptions made in making the argument for the efficient market theory. Crotty argues that this ideology has led to greater and more destructive crises because of flaws inherent in the NFA. In the 2008 paper he argues that the efficient market hypothesis is itself flawed. The paradigm creates perverse incentives for actors in the financial sector; the root cause of the crash in mortgage backed securities were deliberately made to be opaque products; this built up unknown and excessive risk; and the risk-taking led to highly leveraged institutions that were unstable and prepared to crash (Crotty 2-4).

What we see under the NFA is a perfect illustration of people responding to incentives. Crotty speak in this paper of the foundations of the NFA being the “assertion that the realism of assumptions does not matter in evaluating the validity of the conclusions” (12). This set up feels extremely unscientific. It is an ex-post justification in service of capital. It is an argument by the criminals against policing. Were it not made by already-established voices in the service of making people richer, it would be questioned. Of course, all models are by necessity simplifications of reality – but this predominate paradigm of financial economics makes the assumptions first. In the real world leaning on false assumptions leads to crashes that could not have happened because the VAR model was working with faulty assumptions, and structural linkages bring everything down. It’s not a good system, but it seems to persist. As Crotty writes, “the methodological debate, therefore, is not about whether abstraction is necessary, but whether or not we should favor theories whose assumptions are not excessively and unnecessarily at odds with the reality we wish to theorize” (13).  Deregulation happens because of these motivated false assumptions lead to faulty models. This makes the entire system more fragile to shocks. 

By 2011, Crotty had a little more distance from the full-depth urgency of the crisis in progress. In his newer paper, he extends his argument from his earlier 2008 paper in more detail, looking the effect of the deregulation and consequences of mindlessly following the NFA in the financial system. Deregulation led to increases in complexity, size, volatility, and linkages of the global financial system. These facts increased size and depth of the crisis of 2007-8 when it hit. Crotty proposes that we need to move away from the “NFA” and towards a theory of regulation that is based on the thinking of Keynes and Minsky. Minsky and Keynes both had views that said unregulated markets are unstable and vulnerable to crashes. As in his prior paper, Crotty is critical of the efficient market based new financial architecture, continuing to argue the assumptions behind the efficient market theory do not reflect reality and should be abandoned. In this 2011 paper, he looks deeper at the “positivist” methodology as defined my Milton Friedman in 1953, where Friedman claims that realism of assumptions doesn’t matter, and even if they did the potential realism of the assumptions would not be able to be parsed out (7).  For Crotty, basing your entire financial architecture on these foundations is the fundamental basis for crisis formation. Instead, he argues, we should look back to Keynes, who argued that we need to look to reality for the basis of our theories and look to Minsky’s structural models of the economy in a growth phase and be prepared for the next crash. 
Crotty had moved on from the initial crisis in 2011, and the next part of his project is in building a new paradigm: “Rather than searching for an assumption set that can demonstrate that financial markets are efficient, economists should construct a set of realistic assumptions about financial markets and ask: what hypotheses about the behavior of financial markets can be derived from these assumptions? (10). And that’s what he does, building a set of ten key assumptions emphasizing “endogenous dynamic processes” (17), assumptions like “The future is unknowable” and “liquidity changes over time” (17). These are assumptions that we have seen as fundamental building blocks of what the financial economy does as it moves through time in a dynamic process. The real challenge, Crotty says, is to “understand how sensible agents make decisions under conditions of uncertainty or un-knowledge” (18-19), a huge change from the dominate paradigm which assumes perfect knowledge from economic actors. 

If the we a society persist so that the paradigm that dominates is the New Financial Architecture, then it makes it so that there are no strong regulations. This to me validates the Minskian and Keynesian view where it feels like crashes are inevitable, as Crotty argues. As we saw above, even a stable financial system contains the seeds of its own destruction and borrowers keep reaching for yield and overpaying for assets as they increase in price (Something that can of course never bee identified but in retrospect; bubbles always have happened in the past but the assets price increase in the current moment always represents a new paradigm).  Unfortunately, what seems to have happened is that the vast rulemaking apparatus that was supposed to go into effect with Dodd-Frank, itself watered down by the existence of a new class of legislators, will not be put in place. Instead we have tax cuts and continued increases in the American stock markets that justify the boom. I’m afraid the next crisis is sooner than any of us would like it to be, since fealty to the NFA in the financial economy has feedback effects to the real economy. Thinking the market is efficient not only poisons the financial markets, but it also means that people look at the labor market and see not the need for intervention, but workers who need to accept less in wages while those who crashed the economy get bailed out and the cycle starts again because we have no answers on how to fix it in the NFA. It has been eight years since the last missive, and Crotty’s books will go out of print as we go about our process of forgetting.