From American Affairs Journal:
Remember auction rate securities? For
decades, financial institutions hosted “auctions” of these fixed-rate
instruments for buyers and sellers. They were considered so safe, and
the auctions (where the interest rate would be “reset” depending on the
level of interest in the securities, among other factors) so routine,
that auction rate securities became an alternative to money market funds
for those wanting a short-term, interest-bearing investment.
Until they weren’t. In a kind of prelude to the mortgage crisis, the auctions began “freezing up” in 2008 and “failing”—that
is, sellers could not find buyers. Financial institutions had
implicitly agreed to backstop the auctions by buying up excess supply,
until they too simply stopped, leaving holders of auction rate
securities (ARS) without a ready market. For years afterward,
significant amounts of almost worthless ARS rattled around financial
firms and customer inventories.
The ARS debacle is one of the few financial events of the last century that Finance in America: An Unfinished Story
does not mention, but it illustrates several themes that Kevin R. Brine
and Mary Poovey present as central to their study in this truly
magisterial history of the American financial system. Finance in America
will be the textbook for a generation or more, for those wishing to
understand what has become one of America’s most prominent economic
sectors. Brine and Poovey weave their themes through a detailed
narrative that examines developments in corporate organization,
accounting, finance, and economics from the late nineteenth century
through the 2008–9 financial crisis. The book is artfully comprehensive,
examining topics such as stock analysis and valuation, economic
forecasting, the development of stock indices, the increased importance
of data and mathematical economics, portfolio theory, Keynesianism and
monetarism, and econometrics, among others. Brine and Poovey place
well-known giants such as Benjamin Graham, David Dodd, and Milton
Friedman in context alongside the many other contributors to the
American financial system and related scholarly areas. The book is also
archivally rich, drawing from textbooks, conference papers, accounting
materials, and other almost forgotten material. Despite the technical
nature of the subject, the book is clearly written, and its readership
need not be restricted to professionals or academics.
The Mathematical Turn in Economics and Finance
Central to the story of American finance is the “mathematical turn”
in economics, beginning in the twentieth century. The book features an
in-depth look at the contributions of economist Irving Fisher, in
particular, whose works in the early part of the twentieth century, such
as The Nature of Capital and Income (1906) and The Theory of Interest
(1930), brought a new focus to the study of finance. Fisher is
important for a number of reasons, including the fact that his 1891
doctoral dissertation introduced the concept of marginal utility into
American economic analysis. Fisher led the way in turning economics away
from its relationship with philosophy and ethics toward mathematics.
His definitions of “capital,” “income,” “wealth,” and “risk” were
oriented toward expectations about future income, in contrast to the
more static picture of value presented by neoclassical economists. Brine
and Poovey also explore everything from the econometric analysis of
Norwegian economists Ragnar Frisch and Tryvge Haavelmo to work done in
statistics and econometrics during World War II. They then trace the
subsequent transfer of these developments to financial markets through a
series of conferences in the 1940s, as the nation reverted to
peacetime.
But finance is not simply math. Financial economics may be able to
achieve a level of theoretical precision, but as this account shows, it
is not a science in the way physics is. The book acknowledges “the
consolidation of finance as a gradual, uneven process without losing
sight of the heterogeneity of its components or the capaciousness of
what it has now become.” How one defines a balance sheet, what to
include as a “capital good,” and the creation of indices or stock
valuation techniques are not questions with objective answers
independent of time or con text. Indeed, the discipline of “finance” on
this account is largely a graft onto other disciplines such as
mathematics and economics, and it also served (and continues to serve)
political purposes.
In a surprisingly gripping section, Poovey and Brine recount the
development of the concept of “gross national product” (GNP) in the
1930s and 1940s. As the authors show, the development of this concept
came with serious methodological and conceptual challenges. For one
thing, the principles of corporate accounting could not be perfectly
applied to a nation; a nation’s tax revenue is not “income,” and
consumption is not really national “cost.” Nevertheless, in the 1940s,
economist Milton Gilbert wanted to see if consumer demand would hurt the
war effort, or if the war was hurting national economic well-being; he
would resolve these in the negative, arguing that using gross national
product rather than net made more sense. But in doing so, Gilbert really
focused on the health of government.
Others, like Simon Kuznets, had collected data on national income and
production on the assumption that “the end goal of economic activity is
the consumption of real goods and services; and the purpose of
constructing national aggregates is to measure economic welfare.”
Gilbert crucially departed from Kuznets by including a measure of
expenditure as well. Gilbert’s model “implicitly equated the growth of
government (expenditures and costs) with growth of the nation’s economy.
. . .
When the growth of government was equated with the growth of the nation, the policy tool the national accountant provided could be used to justify government growth—and the national accountant became, de facto, an apologist for—as well as an indispensable measure of—the government he measured.” For example, Gilbert added taxes back into the gross
national product, but did not include payment of interest on government
debt to the cost side. This analysis supported Roosevelt’s economic
proposals during the war (as Poovey and Brine note, Roosevelt proposed a
budget that allocated over half the nation’s “income” to defense
spending). Gilbert needed to come up with an analysis that would avoid
inflation as the nation purchased goods, especially those related to the
war effort, at a faster pace. This analysis, however, also drove “the
policies that shaped many Americans’ experience of the war: heavy
taxation, the growth of U.S. debt in the form of Treasury bonds, price
controls, and the rationing of some consumer commodities.”
Indeed, ordinary Americans’ general involvement with the financial
system came about in World War I, with the government’s promotion of
Liberty and Victory Bonds. The authors conclude that “the first stage of
the democratization of the U.S. capital markets was a function of
wartime necessity, patriotism, and ‘celebrity marketing,’” a combination
which Brine and Poovey imply is still very much with us.
For examples like these, at our particular economic and cultural moment, a history of finance is crucially important. Finance in America
shows just how finance is affected by cultural, political, and
conceptual assumptions. Kuznets and Gilbert had both developed
approaches to answer questions about the national economy, but Gilbert’s
was better suited to answer the question then facing the nation. This,
however, implies that our understanding of economic measures inevitably
changes as the critical political questions change. By including taxes
for the practical reason that this was what the government had spent to
win the war, GNP would naturally expand as long as taxes grew. In the
run-up to 2008, and to some extent even today, the nation perhaps
suffers from a different distortion: the mindset that the stock market
and those companies that dominate it simply reflect the objective state
of the American economy. If the “market” does well, in other words, then
the nation does well. But that is not necessarily the case. This
mindset, so established among both right- and left-leaning commentators,
is premised on certain neoliberal presuppositions, which are more
assumed than proven.
Efficient Markets and Rational Choice
Finance in America also demonstrates the periodic failures to
account for irrationality in financial decision-making. As the larger
events of 2008–9 unfolded, a market panic of sorts spread to the ARS
market, which was not the same as the mortgage market that was suffering
a loss of confidence. Nevertheless, customers sought to dump their ARS
holdings because of nervousness about their creditworthiness. Other
investors, for the same reason, decided not to buy ARS as they typically
would. But the buyers, sellers, and the ARS themselves were largely the
same the day before auctions started to freeze as they were the day
after; the investors simply stopped believing in the auction market
itself. This pattern recurred in other areas of the markets. Even before
defaults, some market participants decided that mortgage-backed
securities simply were not worth what the financial models said they
were. Once that happened, the brokerage houses that had relied on the
value of those instruments as collateral to finance their operations
could no longer do so, leading, in part, to a downward spiral. In the
abstract, every credit matches a debit. But it is best not to look down
from the ladder of debt. When that happened in 2008, as John Lanchester
recounted in the London Review of Books (July 5, 2018), “people
suddenly started to wonder whether these assets (which by this point had
been sold and resold all around the financial system so that nobody was
clear who actually owned them . . .) were worth what they were supposed
to be worth.”...
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