Bad Ideas

Reknowned economist James K. Galbraith, one of our expert panelists, pulls no punches in talking about the damage wrought by financial innovation

Global Finance: You are very negative about recent financial innovations. Are there any you see as beneficial?
James K. Galbraith: I could point to the Consumer Financial Protection Bureau. It provides at least one place in the government that is supposed to be looking at financial innovations with a skeptical eye. In my view, innovation in the financial sector is designed to get around public purpose.

GF: Which innovations have been most harmful?
Galbraith: Fraudulent instruments for asset-backed securities, like liars’ loans, NINJA loans, and CDOs (collateralized debt obligations), should top anybody’s list. They institutionalized the criminal takeover of the mortgage business, beginning with liars’ loans and the fraudulent representation of the borrowers and carrying on through fraudulent representation of the risks in the securities. CDOs take the toxic waste of some mortgage-backed securities and combine it with the toxic waste of other mortgage-backed securities and call the results diversified. The whole chain was certain not only to collapse, but to bring down the affected institutions.

But nobody was prosecuted. As a result, I would argue, the financial system cannot recover its reputation. There’s no way to persuade the wider world [of its safety], so every time there’s a little bit of jitters, people jump to US treasury bonds.

GF: What are the shortcomings of the Basel Accords?
Galbraith: The Basel regulating structure immunizes the acquisition of a highly risky sovereign debt in Europe by the European banks. This is a very bad substitute for effective regulation of the actual risk.

GF: What about the Black-Scholes formula?
Galbraith: It cultivates the illusion that the world is governed by the normal distribution and that risks are much smaller than they are. The probability of being catastrophically wrong is much, much higher than the formula would lead you to believe.

GF: How is microfinance harmful? Doesn’t it benefit those who most need capital?
Galbraith: It has fostered a great deal of financial suffering on poor people in developing countries, while at the same time persuading rich people that they’re doing good things—which they aren’t. It is essentially a way of trapping poor people into unsustainable debts and ultimately producing financial meltdowns. That has now happened practically everywhere that microfinance has been allowed to expand, such as in India, Bosnia, Mexico and Nigeria.

Microfinance institutions, for all their do-good rhetoric, are as susceptible to very bad lending decisions on very bad terms as any other badly regulated financial institution. They are characteristically under-regulated; and they charge unsustainable, and in many cases highly misleading, loan terms. They also support industries that really cannot be the source of development, because they basically compete each other into the ground. Examples include one-cow dairies and one-car garages. And their executives are among the highest-paid people in the country. In every way, it’s a microcosm of a dysfunctional banking system. However, effective regulation is possible. It would include supervision of the institutions and effective limits on interest rates.

GF: What about modern monetary theory (MMT)? Is that innovative?
Galbraith: Intellectually it’s built on a “continuist” reading of Keynes, meaning one that treats the General Theory (1936) as a further development of the ideas in the Treatise on Money (1933), a book most mainstream economists have never read, or even heard of. In the Treatise, when Keynes refers to “modern monetary systems” he means banking as it has been practiced for about the last 4,000 years. That’s where the phrase “MMT” comes from, and in that sense, the use of the word “modern” is a bit of an insider’s joke.

But the MMT group is innovative in two important respects.  First is that they’ve worked out how to explain and teach the functioning of “modern monetary systems” in exceptionally fresh and clear terms.  Second, they’ve built a network to keep people engaged, build support. They’ve done this quite brilliantly. As an old Keynesian that they are helping to rescue from dinosaur status, I’m a fan.