Should Our Universities be Named
as Codefenders in the Subprime Pricing Trials?

by
William Krehm

Amongst the key evidence used by prosecutors in such trials would be articles that have begun appearing in The New York Times (20/06, “A Question of Price: A Debate Rages on How to Value Tricky Assets” by Louise Story). Similar debates have raged through the last two or three centuries among economists. To deal with issues so complex Adam Smith, for example, who tried to embrace the complex problems emerging before the industrial revolution, when the driving force in the change was the division of labour within factories rather than the industrialization introduced by Watts energy-driven machines. In Smiths day the latter had still not replaced human muscles as the source of power in Britains factories. But in addition to his labour theory of value - the amount of average labour - Smith knew that there were vital problems that required a different approach - and hence different value theories. Consequently when he was dealing with such other problems, he resorted to two other quite distinct theories of value.

One of these was the cost of production in which he examined the major cost groupings that employers had to meet: labour costs, raw material, financial costs.

And finally when he was concerned with the amount of labour the price of products would command he switched to the amount of “commanded labour” that could be associated with the prices of products. Let me note, in passing, that the latter has become of key importance in our dealing with competition from China and Asia in general. He was in fact on the trail of modern systems theory, but could not yet lay out the complex intertwining of the multiple causal factors that operate in a modern economy.

David Ricardo brought in the rent factor. He and his close friend the reverend R.T. Malthus, agreed to ignore the cost of labour, considering it a constant in terms of foodstuffs since the notorious prurience of the lower orders would always reduce wages to a survival level. So the one great variable factor - until the repeal of the laws on the import of grains in the Britain of their day - was the height of the tariff walls that determined the price of grain, potatoes and other foodstuff. This resulted in an unearned revenue for those who owned richer, more productive land than the average. And this awarded such landowners an unearned revenue. Even more strikingly this analytical construct was transferred to urban real estate, and in our day to the unearned incomes in the entire economy.

Up to the mid-19th century the working classes took little part in these grand debates of the great pioneer economists. Certainly, the labouring classes - mostly illiterate at the time - had little or no access to such swirling ideas. But early in the 19th century private mechanics institutes arose to teach workers how to read and write. Before that happened, discussions amongst economists had been much like frank discussions between husband and wife about local scandals after the kids had been put to bed. However, with the new literacy the youngsters remained very much awake. By the mid-19th century violent debates, if no t actual barricades arose in many of the European capitals. Especially after the Paris Commune (1871) a need arose for an economic theory that would shift the determinants of the distribution of the national income from the workshop to the market place: the concept of value was redefined as the degree of personal satisfaction that the consumer derived from a given commodity. Conceptually a discreet screen was lowered by respectable economists over what took place in the workshop. The consumer market was seen as determining value and just about everything else that counted. But there was an infinity of markets, depending to whom you entrusted the handling of tariff laws, social services, and much, much else. None of this received lasting attention, for the simple reason that the value theory in ascent merely reflected the political power conquered by the group whose class interests the officially recognized theory espoused.

The “Dominant Revenue”

That relationship was best summed up by the late French economist, FranÁois Perroux, who developed the notion of the “dominant revenue” - the income of that group in society that has conquered the political power that caused the welfare of society as a whole to be identified with the revenue of a specific class. Up to repeal of the Corn Law in 1843, it had been the revenue of large landowners, then it became that of the industrial capitalists, and then it was taken over by the national financial sectors.

And more recently the world financial sector.

In Britain, I know of a wise lady who had taught economics at one of the less celebrated British universities, while writing fine books on money creation as according to the views of the Social Credit movement, but now happily retired. Discussing her teaching experience at the university, she got the process right. “I would tell my students, if you get this question on your examination paper, you must answer it so and so. In fact it is not so, but if you give the right answer you will fail the examination, and that will not do you any good.

Clearly, the economics departments of our universities should be in the dock as well for even more basic reasons.

Let me quote from The New York Times (20/6, “A Question of Price. A Debate Rages on How to Value Tricky Assets” by Louise Story): “How much is your investment worth? That might seem like a simple question on Wall Street, where the price of everything from Apple to zinc, flickers across computer screens every day. But inside Bear Stearns, the answer was anything but clear last spring for investors who put their money into two giant, and ultimately doomed, hedge funds.

“Two executives who oversaw the funds, Ralph Cioffi and Matthew Tannin, did not disclose that the funds were plunging in value until it was too late, the authorities say. On Thursday morning, the pair surrendered to federal agents and were charged with nine counts of securities, mail and wire fraud.

“Whatever the outcome, the case spotlights one of the most vexing problems confronting Wall Street as the credit crisis plays out. How to value tricky investments linked to subprime mortgages and other risky debt.

“As the mortgage market melted down last spring, Mr. Cioffi valued one of his funds as having lost 6.5 percent in April. But colleagues at Bear placed far lower values on investments in that fund. They said it had lost 18.97 percent.

“Its a humongous problem for Wall Street, said Michael Young, an attorney with Willkie Farr & Gallagher. These days these valuation obstacles are at the core of the write-downs.

“Mr. Cioffi and Mr. Tannin are the first Wall Street executives to face criminal charges linked to the credit mess. But many other bank executives are grappling with far bigger financial worries. Worldwide, banks have written down the value of assets by $380 billion, as high-flying markets have crashed back to Earth. Some banks hold that the write-downs have been conservative and that some assets may be written back up in the future. Others say the bill will keep mounting.

“Bankers like to say that valuing complex investments is part art and part science, but four large firms have said recently that some employees have not been honest.”

But that is to belittle the problem. As banks have been deregulated and globalized to go on growing at the rate they have been alleged to grow. Derivatives - ever higher powers of acceleration - have been brought in to justify blown-up estimates of future growth rates. These cannot be justified by the alleged present rates of growth and incorporating the drastically higher rates of growth acceleration employing derivatives of various forms. However, the future in which this is to take place can only come bristling with unpleasant surprises, if only because our environment is already severely strained and damaged by the human encroachment already suffered.

The part “science” that bankers are quoted as attributing to the art of evaluating complex investments is not partly, but wholly bogus. The mathematical device of calculus supposed to bring some science into the picture, if only in a partial way, is simply not able to do that. The factual or empirical input of any mathematical tool is nil. Mathematics provide powerful tools of analysis, but in themselves have zero factual content. That must be fed them, and if the fare to which the mathematics applied does not correspond to the reality of the problem, the result is doomed to be misleading nonsense leading to catastrophic results.

Moreover, the technique of integration and derivation is based - one the reverse of the other - on ignoring second order growth rates, on the ground that those second rates are so infinitesimally tiny that you can ignore their second - and higher rates of growth. How then could you deduce anything - including derivatives of future growth by calculus from the current growth of ever more gigantic international banks into which future growth rates, moreover, has been worked with the mathematics of exponential growth? “Exponential” which otherwise educated folk who are not economists take to mean “very, very big.” That is an infinite understatement. It refers to a mathematical expression set up so that the growth rate attained always equal the rate of increase of that rate. It is in fact the mathematics of the atomic bomb, which took a few seconds to explode over Hiroshima.

Obviously these are grounds for the prosecutors hauling the heads and accomplices of the economics department into court on charges hardly less grave than the two high executives from Bear Stearns have had to face. Unless you tackle the subprime investment problem at its real source, you are doomed to complicate the mess further.