Blogging some Thoughts on Anghel Rugina and our Financial Crisis

Our Financial and Economic Crisis

I just reread the economics article, “Is there anything new to be said after Adam Smith, Marx, Walrus, and Keynes? Toward a third revolution in economic thinking” by my old inspiring college professor from Northeastern University in Boston, Anghel N. Rugina: International Journal of Social Economics, Vol 26 No. 10/11, 1999, pages 1227-1248.

Anghel Rugina is prescient about the failure of monetary policy in the face of the irrational features of our financial and economic system and predicts something rather similar to what we are now experiencing. He states that a “Great Transformation” is coming because unsolved accumulated basic problems in our financial system and economy cannot go on indefinitely. “Toward the passage into the third millennium or shortly thereafter, whether we like it or not, for better or worse, we are exposed to the Great Transformation, a historic event to clean the house of the errors made during the twentieth century.” (§5 in his paper, p. 1229)

He faults irrational financial mechanisms of disequilibrium, i.e., the paper-dollar, monetized credit of banks, and pure speculation that is detached from actual investment for productivity. These factors make our current financial and economic system unstable.

He couches his critique in a holistic social economic approach, but sees the factors for disequilibrium making rational, really effective economic, monetary policy, and even business decisions impossible.

His description of equilibrium is comprehensive:

§3: How can we realize in real life and maintain over

time (dynamic process) not just maximum profit for entrepreneurs, as customarily assumed, but the optimum allocation of available human and natural resources so that we may have simultaneously price stability (equilibrium prices with simple and finite fluctuations), full employment (with no large pockets of involuntary unemployment), a balanced public budget every legislative period, a normal rate of economic growth to satisfy the effective demand of active population, a normal rate of profit to cover the real cost of management (equal to the opportunity cost), a foreign exchange rate to assure a balance of international payments in order and not less important, a most equitable distribution of national income and taking care of those who are really handicapped.” (p. 1228)

Paper money, he argues, fluctuates too much and he argues for what he calls Numeraire-currency which harks back to some constant magnitude of a certain commodity (gold, silver, etc.) (page 1233).

I would add, the value of the dollar relates to our government, economy, and country’s standing behind our currency. When our standing in the world falls, the faith in the symbolic value of our dollar can fall as well. In these institutional matters believing something to be of value gives it value. Believing it doesn’t (like rubles in Russia a good while ago) can make people use cigarettes as currency.

Rugina argues: “The business of ‘monetized credit’ [by banks] is nothing but a form of pure speculation in lending something you do not have (‘empty figures’ in the books of a bank) which is accepted on the market because we trust that the bank in question possesses the amount in question but in reality the bank does not have it! And this lending of ‘empty figures’ is done for an additional profit by charging regular interest rates! Further, the same opportunity to monetize credit means financial power.” (p. 1232)

He first sees a moral problem in lending what the bank does not have and charging interest to boot. But strictly economically, it again makes currency and credit unstable. I believe he may well be explaining the credit freeze in the banks, because each bank knows that the other does not have the capital behind the loans they have given. In a boom, it can go by unnoticed. In a bust it exposes the insolvency of the bank. Thus the plan has become to inject capital in banks and to guarantee their loans to other banks. This new approach seems to provide evidence for Rugina’s theory of destabilizing monetized bank credit.

He argues that real investment enhances productivity, but the money set aside for pure speculation is actually responsible for our lack of full employment, because it could have brought more production by actually being invested in it. By pure speculation, money is received in a completely irrational way unrelated to real production and service. It gives financial power to a small elite, makes mergers possible that short change the workers, and redistributes money to the top. Financial transactions that go into production bring equilibrium, while those for mergers and pure speculation are disequilibrium transactions and bring about disequilibrium prices (page 1234). (That means wildly fluctuating prices.)

I would ask: What are these disequilibrium prices but pure speculation infecting regular prices? The housing boom here put handy-man specials, houses that you could not live in, at half a million dollars! Speculative irrationality I would argue infected housing and caused that bubble, just the same way that it produced the dot.com bubble, and the Dutch tulip bubble when the “Bourse” was young, to reach into history.

I have heard an opposing argument to Rugina next argument. He uses a distinction between real buying and selling, where the seller is handing the real object in question and where it is make believe, i.e., where no object exists.

The latter are pure speculations or genuine gambling, where the buyer puts an order to buy (future delivery) but with no intention to take possession of the item in question. He just believes that the price will go up and if so on delivery day he will liquidate the contract and reap a differential profit. This is a bullish spectator. Simultaneously a bearish speculator who believes that the price of the same item will go down will put a different order to sell short and if indeed the price goes down then he will be the one to reap the differential profit (page 1233).

For the opposing argument: a farmer needs capital in advance and receives it from futures to plant his crop. I believe Rugina would not call that speculation but actual investment in production. But the whole futures market goes well beyond helping production with advance capital, thus most likely bringing the instability and irrationality that Rugina warns us about.

Rugina insists that there needs to be institutions and a legal framework commensurate with the kind of mixed economy that exists. I remember in class how he would chant that the free enterprise system spelled freedom! Freedom! Freedom! He would actually chant that phrase. But he said the capitalist system needed to monitored and have gauges and dials and instruments (let’s face it, fair regulation) like the cockpit of an airplane for it to give us the smooth flight into the equilibrium he described and I quoted here at first.

Rugina writes a very rich and important article to which I do little justice here, especially because I don’t understand many of the issues involved. Hope I’ve shed some light on our crisis, however.

Now to think about the mortgage default and foreclosure problem:

In terms of the continuing bleeding and hemorrhaging of bank capital, because of mortgage defaults, I imagine that when the prices of the houses go down below the amount of the loan mortgaged, rather than the debtor just walking a way from the house and allowing it to become foreclosed, a deal could be struck with the debtor for a mortgage equal to the market price of the house at an affordable monthly rate. When the price of the house rises again, the equity would be shared by the bank and the debtor up to the amount of the first mortgage with 5% interest. When those holding a mortgage walk away from their house and the foreclosure becomes necessary, the losses to the banks decapitalize them, far beyond the value of all their assets forcing them into merger or bankruptcy.

With defaults, the derivatives developed from these mortgages also lose their value and these derivatives evidently represent a 535 trillion dollar, unregulated market!

When the hemorrhaging is stopped, the derivatives could fluctuate in equal proportion to the percentage of the new mortgage to the first one, making it possible to determine the value of the derivatives, and they too could include recovery of value when housing prices increase again.

I wonder if this could work. Some way has to be found to prevent the vicious circle of downward spiraling housing prices, mortgage loans exceeding the market price of the house, defaults, and foreclosures.