The Washington Post reports that, testifying before a panel investigating the financial crisis, Henry Paulson “cautioned against overreaching on financial overhaul legislation now before Congress that he said could stifle innovation in the markets.” Well, we certainly wouldn’t want to do that! After all, financial innovation has been great for the economy right? Maybe not, but as Yves Smith notes, it has certainly been good for the finance sector and for financial innovators, as both empirical and theoretical studies argue. This suggests to me that Paulson, former head of Goldman Sachs, may not be thinking of the good of the society as a whole when he worries about the impact of financial regulation.

That being said, I don’t think any financial regulation coming out of Congress is likely to have much bite. Indeed, the Federal Reserve may have already had the regulatory power to avert the crisis but failed to exercise it, according to Bill Black (this post lays out his argument with links to video of his testimony on Lehman Brothers). This should come as no surprise, since the regional Federal Reserve boards are elected by bankers. Tom Ferguson points out that Obama was the candidate of finance, getting more of his early donations from them than any other candidate. If finance owns Congress (as Dick Durbin memorably said), the Federal Reserve and the White House, where is effective financial regulation realistically going to come from? continue reading…

(This is the testimony of Levy Institute Senior Scholar James K. Galbraith before the Senate Subcommittee on Crime, Senate Judiciary Committee, May 4, 2010.)

Chairman Specter, Ranking Member Graham,  Members of the Subcommittee, as a former member of the congressional staff it is a pleasure to submit this statement for your record.

I write to you from a disgraced profession.  Economic theory, as widely taught since the 1980s, failed miserably to understand the forces behind the financial crisis. Concepts including “rational expectations,” “market discipline,” and the “efficient markets hypothesis” led economists to argue that speculation would stabilize prices, that sellers would act to protect their reputations, that caveat emptor could be relied on,  and that widespread fraud therefore could  not occur. Not all economists believed this – but most did.

Thus the study of financial fraud received little attention. Practically no research institutes exist; collaboration between economists and criminologists is rare; in the leading departments there are few specialists and very few students. Economists have soft-pedaled the role of fraud in every crisis they examined, including the Savings & Loan debacle, the Russian transition, the Asian meltdown and the dot.com bubble.  They continue to do so now.  At a conference sponsored by the Levy Economics Institute in New York on April 17, the closest a former Under Secretary of the Treasury, Peter Fisher, got to this question was to use the word “naughtiness.”  This was on the day that the SEC charged Goldman Sachs with fraud. continue reading…

There is nothing lovable about Goldman Sachs, and its recent grilling by the ominously named Senate Permanent Subcommittee on Investigations understandably drew a lot of attention.

We should not, however, obscure the reality. Goldman Sachs is a bank, and except for questions about the Abacus deal, in which it’s accused of disclosure failings, Goldman was doing what modern banks do. In collateralized debt obligations and credit default swaps, it wasn’t the biggest player.

So question for Congress isn’t whether Goldman did the right thing. The real question is, why on earth were banks allowed to do the things that Goldman was doing?

The late Hyman Minsky had something to say about this. In a paper from 1993, he was clear-eyed about the role of institutions like Goldman:

Essentially these operators have superior knowledge about their customers who need financing. . . and their customers who have a need for outlets in which money can be placed. They turn this private knowledge of the conditions under which funds are desired and the conditions under which funds are available to their own advantage, even as they perform the social function of selecting the investments that the economy makes.

Each of these financial intermediaries, Minsky well knew, “has an agenda of its own: they are not charitable institutions.” But they play a crucial role in the most sensitive aspect of capitalism, which is lending. And lending, Minsky said, is capitalism’s Achilles heel, a kind of fatal flaw whereby growth breeds instability. continue reading…