Mac 1.2

From the 1960s to the mid-1990’s Government around the developed world spent in good and bad times. In fact, they spent more than they willing to pay in additional pain to the taxpaying public. So they ‘borrowed’. Politics thereby raised the ceiling. The ceiling only began to come down when ‘deficit and debt’ became the political mantra of the industrial world and interest payments on the national debt the largest single and least satisfying pleasure paid for out of the public purse.

By the late 1990s, deficits were slashed; debt began to shrink; and, social infrastructure built up over two generations crumbled but fortunately did not collapse. As the 21^st century begins, the word ‘surplus’ has even re-entered the political vocabulary. Inevitably, perhaps, the heat generated by all the public policy spheres rubbing up against each other is threatening to raise the ceiling once again. Jockeying to be first to fill its specific ‘deficit’ incurred during the ‘slash and cut’ of public debt and deficit reduction, each public policy sphere is raising its profile before the political public. Collectively, their wants, needs and desires threaten macroeconomic goals such as economic growth (increasing potential real GDP) and price stability (low inflation). If the GDP pie grows and the cost of its slices does not increase then more public pleasure may be had with no increase in public pain in the form of taxes or interest payments on the national debt. If not, some will win and some will lose. It is to the naming of these various Canadian spheres of political influence that now I turn.

As a federation, Canada has had amply time to sort out the naming of these spheres of public policy. Since at least 1918 with the founding of the Dominion Bureau of Statistics (now Statistics Canada), the federal and provincial governments have come to agreement on certain terms. These became embodied in The Canadian System of Government Financial Management Statistics (CSGFMS). In 2001 the system became a victim of globalization and a general decline in the quality of the publicly generated statistical evidence. One thing is certain, it will take decades to develop actionable time series.

The FMS was founded on a modified-cash based system of accounting. Recently, Canadian governments have decided to move from that modified-cash based accounting system to an accrual based accounting system. In addition, an internationally accepted Government Finance Statistics (GFS) manual has been developed. The GFS 2001 is an internationally accepted accrual accounting framework for government finance statistics. The GFS 2001 is also fully integrated with the United Nations (UN) System of National Accounts (SNA) framework. Given these changes, the Canadian statistical system underlying government finance statistics must also change. Statistics Canada has decided to move towards reporting government finance statistics on a Government Finance Statistics 2001 (GFS 2001) basis.

In the following I will deal with the original 'made-in-Canada' system. The CSGFMS was used for purposes of the Fiscal Arrangement Act between the federal and provincial governments. The CSGFMS was used to calculate, among other things, equalization payments by the federal government to the ‘have-not’ provinces of the country. Next to the System of National Accounts (to which it is fully compatible), the CSGFMS was the most important system of economic statistics in Canada.

For purposes of illustration please find below top-level CSGFMS terms used for: a) assets & liabilities of government in Canada; and, b) revenue and c) expenditure items. These terms are top-level in that each is composed of various sub- and sub-sub-categories (CSGFMS, Statistics Canada Catalogue 68-506, Occasional).

Taxes
1. Personal Income Taxes	14. Succession Duties & Estate Taxes
2. Payroll Taxes	15. Gift Taxes
3. Corporation Income Tax	16. Health Insurance Premiums
4. Taxes on Insurance Premiums	17. Social Insurance Levies
5. Other Taxes on Corporations & Businesses	18. Universal Pension Plan Levies
6. Taxes on Certain Payments & Credits to Non-Residents	19. Other Taxes
7. Real & Personal Property Taxes	Non-Taxes
8. General Sales Taxes	20. Natural Resource Revenues
9. Motor Fuel Taxes	21. Privileges, Licences & Permits
10. Alcoholic Beverages Taxes	22.Sales of Goods & Services
11. Tobacco Taxes	23. Return on Investments
12. Taxes on Amusements & Admissions	24. Other Revenues from Own Sources
13. Taxes on Other Commodities & Services	25. Miscellaneous

The traditional instrument holding government, at the federal and provincial level, accountable is the ‘Budgetary & Public Accounts Cycle’ or BPAC. The cycle begins with submission of an annual Budget to the legislature as well as a set of spending Estimates by agency, department and program. Together, the Budget and the Estimates form a government's financial plan for the coming year. The cycle ends with publication of the Public Accounts reporting actual spending about two years later. What follows has been extracted and edited from my Government in Canada journal article: The 1995-96 Federal Cultural Budget: A Case Study in Canadian Government Budgetary Information.

In theory, the BPAC permits one to assess if a government is "putting its money where its mouth is!" Words and numbers are cheap, especially in the heat of political debate and media glare. All sorts of promises and threats may be made -- but does government keep its word? BPAC should hold government accountable by making its actions transparent to the legislature, the general public and all communities of interest including the cultural and financial communities.

The BPAC consists of eight separate documents in three distinct sets: the Budget; the related Estimates; and, the Public Accounts. The three are published by three different agencies – The Department of Finance, Treasury Board and the Auditor General – each often using different data and definitions.

The Budget presents the government's financial strategy and consists of four documents produced by the Department of Finance. The Budget Speech presented by the Minister of Finance in the House of Commons; and the Budget Document, expanding upon the Minister's speech that establish the Government’s strategy; the Budget in Brief, spotlighting selected budgetary actions; and, the Budget Plan, supplementing and detailing information presented in the first three, as well as presenting ways and means motions to be tabled in the House of Commons.

The Estimates represent tactics that support the government's strategy. Produced by Treasury Board, the Estimates report to the House of Commons by Vote, Activity and Program for most, but not all, federal departments and agencies. Furthermore, the Estimates define the logistics behind the government's tactics using dollars, person years, and (less frequently) federal standard objects of expenditure. The Estimates consist of three documents, one of which (Part III) comes in multiple volumes:

· Part I - Government Expenditure Plan describes relationships between the Budget Plan and the Estimates;

· Part II - Main Estimates describes resources for individual departments and agencies and requiring spending authority from the House though a Vote; and,

· Part III - Expenditure Plan reports, in 78 separate volumes, for most federal departments and agencies. Agencies not reported to the House through Part III generally issue an annual report and a financial statement, e.g. the Canada Council. Such annual reports are not considered in this article.

The Budget and the Estimates are complex, self-contained documents drafted by two related but distinct departments of the federal government. Each has its own objectives, perspectives and priorities. Often similar information appears contradictory and/or at variance when reported in different documents and even different volumes of the same document. Thus, with respect to the Estimates, there are variations for which there are apparent and sometimes substantive differences. First, with respect to Part I - Expenditure Plan and Part II - Main Estimates:

Second, since 1986 Part II reports only main estimates for both the current and forthcoming year. But in any given year a government introduces Supplementary Estimates increasing or decreasing proposed spending. These changes are no longer reflected in Part II. Similarly, government may not spend all monies voted by Parliament. These differences too are not reported, year over year, in Part II.

Prior to 1986, these adjustments were reported under "forecast estimate" for the year finishing. While not an actual figure, the forecast allowed some sense of this year's estimate relative to last year's likely spending. In fact, previously Part II provided five years of data including three years of actual spending, one year of forecast and next year's estimate. This change may, or may not, reflect the ascendancy of commercial chartered accountancy (reporting two years of data and adjusting definition of expenditure items required by changing circumstances) and traditional practice in both registered industrial accountancy (up to ten years of data with constant definition like the banks) as well as public sector accountancy (at least five years). Nonetheless, credible statistical trend analysis can only be conducted with at least five years of data.

Third, Part III (introduced in 1986) reports for each of 78 individual departments and agencies in separate volumes. In many cases Part III displays five years of data including estimated spending for the forthcoming year, forecast spending for last year and actual spending for the previous three years. But these are reported only department-by-department, i.e. no single figure for the federal government as a whole is available in Part III.

Fourth, federal programs with which communities of interest are most familiar are usually not reported in the Budget and may not be reported in the Estimates. Thus, the Estimates report "Votes" of the House of Commons. For example, grants and contributions under "Cultural Initiatives" (a program very familiar to the cultural community) are part of "Vote 10 - Grants and contributions: Canadian Identity Program, Canadian Heritage". This means distribution within the Canadian Identity Program is, to a great extent, a ministerial or bureaucratic prerogative and priority. Thus latitude is provided to officials permitting "back-pocket" budgeting whereby ministers or bureaucrats may, if they wish, play one group against another without published information by which they can be held accountable.

Fifth, there are in excess of 25 consolidated specified purpose federal accounts reported as a single entry in Part II in the "General Summary" to the Main Estimates. But these accounts are not described or even named in Part II. An accounting of these funds (reduced as planned or not) will be available only in the Public Accounts to be published in two years.

It is important to appreciate the "wiggle room" provided by these limitations within the federal Budget and Estimates. The government can, in effect, quote different numbers to suit different purposes. Consider, for example, global federal spending. According to Part II - Main Estimates, total federal spending for all departments, agencies and specified purpose accounts will increase 2.3% from $161.1 billion in 1994-95 to $164.8 billion in 1995-96. Excluding specified purpose accounts, spending by all federal departments and agencies will increase by 6.2%. But if one then excludes the Public Debt Program of the Department of Finance, then spending by all federal departments and agencies will increase by only 1.7%.

And if one uses Part I and considers only federal transactions with outside parties (including public debt payments) and includes planned savings (requiring parliamentary approval) and anticipated lapsed spending (allowing for reserves), then total federal spending will increase by only 0.4% over 1994-95.

In fact of 25 departments and agencies reported in the 1994-95 "General Summary" of Part II, eleven will increase and fourteen decrease. Thus the Department of Finance will experience a 19.1% increase while the Public Debt Program will increase only 17.3%. Accordingly, excluding the Public Debt Program, the Department of Finance budget will increase 28%.

In the Budget Plan, however, the Minister does not provide data directly comparable with the Main Estimates. Rather he claims departmental spending will decrease 19% over the next three years. Because such cuts include "out years" they are subject to more uncertainty than cuts proposed this year. Accordingly, one can say federal spending will go up 2.3%, 6.2%, 1.7% or 0.4%, or it will decline 19% over the next 3 years. Which statement is "true"? Does the current format for the Budget and Estimates provide accountability and transparency of the Government to public scrutiny?

To conclude, consideration is paid to issues of comparability and definition and how government could be more like ‘business’ with dramatic effects on public finance.

While the Main Estimates can be used to calculate the federal budget for any given public policy sphere, more detailed data is available in Part III which provides estimates for both the current year and the past year as well as forecast data for the past year and actual data for the previous one, two and sometimes three years. There are, however, three problems associated with Part III.

First, cost is a problem. Together, Parts I, II and III (78 separate reports) cost $960.85 plus GST. Separate annual reports are also be required for each cultural agency not reporting through Part III. With Budget documents, the cost (not including time and effort in adding up data for all relevant departments and agencies) is well over $1,000.00. This is the minimum price of accountability of federal spending to public scrutiny. This cost could be significantly reduced if the pre-1986 format for the Main Estimates was reinstated reporting five years of data.

The federal government has, however, made the Budget and Estimates available in electronic as well as paper format. This does not mean electronic information is free. Federal policies are, at present, ambiguous and subject to differing departmental policies. Treasury Board, for example, tends to make electronic products available to libraries at no cost, while the Department of Finance applies a cost-recovery policy in some cases, e.g. detailed budget papers. Parts I and II of the Estimates are now available in electronic format.

Second, Part III presents other compatibility problems. Thus while the Participation and Official Language Support components of the Canadian Identity Program are reported for five years, sometimes down to the level of grants and contributions, the Cultural and Heritage Development component is not. Similarly, Parks Canada and Corporate Management are reported for only this year's estimates, last year's forecast and one previous year's actual spending. This inhibits trend line analysis that requires at least five years of data. Furthermore, while total budgetary requirements of cultural agencies are reported in Part III for five years, data at the activity level is available only in Part II - The Main Estimates for last year's and this year's estimates.

Third, even if one used all 78 volumes of Part III, data will not necessarily agree with the Public Accounts for the corresponding year. Formats of the Estimates and Public Accounts are not compatible.

It is clear from calculating the federal cultural budget that definition of management or administration varies between departments and agencies. Without a compatible definition it is not possible to determine resources directed at providing the Canadian people with goods and services.

For accountability and transparency of government actions to be accessible to any Canadian or community of interest, government spending in any public policy sphere such as culture should be reported in one place, at one time and at a reasonable cost. This would require, of course, formal recognition of "legitimate" communities of interest not rooted just in geography or political allegiance but also in "conceptual space" where, nonetheless, they exist as "real" public policy spheres of influence.

That this is possible is evident in France with respect to international cultural relations. Since 1982, the Government of France has required all departments and agencies to make an annual report concerning international cultural relations (État récapitulatif des crédits concurrent à l'action culturelle de la France à l'étranger, No. 82-126 du décembre 1982). The results are compiled and published. A similar approach is possible in federal cultural as well as all other public policy spheres.

Similarly, spending consequences of all government actions should be accountable and transparent to public scrutiny by any Canadian or community of interest. But for this accounting to happen, it should be reported in one place, at one time and at a reasonable cost. Reinstatement of the pre-1986 format for Part II - The Main Estimates would be a useful first step. It would also provide a timeline supporting trend analysis and therefore measurement of the momentum of government towards its long term objective, i.e. to fulfill its democratic mandate. This would require, of course, that actual spending, not just will-o'-the-wisp promises or threats, be reported.

A significant second step would be the re-design of all three parts of the public accounts cycle -- Budget, Estimates and Public Accounts -- using the same definitions and parameters.

I will trace the origins of three central banks, the Bank of England, the Federal Reserve in the United States and the Bank of Canada. As will be seen the Bank of England was created to finance defense spending while both the Bank of Canada and Federal Reserve were created in response to financial crises. In both – Canada and the United States - creation of the central bank represented institutional recognition that the financial community could not be trusted to contain its animal spirits and ‘excessive exuberance’ while Government could not be trusted to keep its hands off the printing press. The central bank arguably represents a 4th order of Government - executive, legislative, judiciary and central bank. It marries Government to Finance in a capitalist economy.

Founded as a private corporation in 1694 the Bank of England was intended to finance defense spending and serve as the Government’s banker and debt-manager. By contrast the Bank of Scotland (also a private corporation) was founded in 1696 to support Scottish business. It was the first bank in Europe to print its own banknotes and continues to do so.

By 1781 the Bank of England had effectively become ‘the banker’s bank’ accepting deposits from and providing services to other banks. In 1844 the Bank Charter Act linked banknotes to gold reserves and the Bank of England was granted the sole right to issue banknotes in England & Wales. An exception was made, however, for private banks that previously enjoyed that right. The last private banknotes in England were issued in 1921. Nonetheless, certain Scottish and Irish (Ulster) private banks still retain this right. It should be noted that their banknotes are not technically legal tender but rather promissory notes like cheques.

In 1870 the Bank of England was given the additional responsibility for interest rate policy. Then in 1890, during a severe financial crisis, centred on the Baring Bros Bank, the Bank of England became ‘lender of last resort’ in order to stabilize the financial system during such financial crises.

From its foundation in 1694 until 1946 the Bank of England was privately owned and operated. Under the post-war Atlee Labour government, however, it was nationalized and until 1997 was state-controlled. In 1997 under the Blair Labour government the Bank of England again became a privately held corporation and was granted operational independence over monetary policy in the United Kingdom.

The first Bank of the United States was created in 1791 by an act of Congress to serve, like the Bank of England, as the Government’s banker and debt-manager. Like the Bank of England it was a private corporation. Unlike the British, however, it was intended to be a truly national bank. In 1811 its charter lapsed and Congress, for regional political reasons, failed to renew it.

In 1816, the second Bank of the United States was created primarily in response to government debts incurred during the War of 1812. Its charter was for 20 years but in 1833, again for political reasons, President Jackson issued an executive order ending deposit of federal funds which instead were placed in state chartered banks. After its charter expired in 1836 it became a purely private bank and then went bankrupt in 1841.

A series of financial crises racked the United States in the mid- to late 1800s climaxing with the 1907 Panic known as the Banker’s Panic. It led to runs on all banks and the entire financial system appeared near collapse. A white knight appeared, however, in the guise of financier J. P. Morgan, one of the richest men in America. Organizing other New York bankers and industrialists like John D. Rockefeller – the richest man in America - Morgan pledged enormous sums of his own money to stabilize the financial system.

While many in industry and government praised Morgan for his initiative many were gravely concerned that the fate of the nation’s finances rested on self-interested private charity. Accordingly in 1908 Senator Nelson W. Aldrich established and chaired a commission to investigate and propose solutions. This led to creation of the Federal Reserve System in 1913.

Unlike the Bank of England and the Bank of Canada the Federal Reserve is regional as well as national in character. There are 12 district federal reserve banks in Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, San Francisco and St. Louis. The regional character of the system allows variations in monetary policy deemed appropriate for the differing economic conditions in the various regions.

In addition to the 12 regional Federal Reserve Banks with their own managements, there is a seven member national Board of Governors appointed by the President and confirmed by the Senate to serve 14-year terms of office.

Significantly, unlike the British and Canadian systems, there is no branch banking in the United States. Rather local branches retain reserves in their own vaults. Under branch banking reserves are generally held at head office. The regional nature of the American experience began as fear by the slave-owning South of the emancipationist industrializing North. The U.S. simply could not accommodate a truly national bank or a branch banking system. Failure of the first and second Banks of the United States as well as the constitution of the Federal Reserve speak to, among other things, this regional opposition to national financial centralization.

During the pre-Confederation period the provinces of British North America issued, from time to time, treasury notes that served as legal tender, e.g., Prince Edward Island in 1790 to make up for a coin shortage, a common problem among the provinces. Various private banks also issued banknotes beginning with the Montreal Bank (later the Bank of Montreal) in 1817.

Under the British North America Act, the federal government gained jurisdiction over currency and banking and the Dominion Notes Act came into effect in 1868. The new federal government assumed responsibility for provincial notes. In 1871the Bank Act repealed all provincial acts conflicting with federal jurisdiction over currency and banking. Thereby chartered banks came under common regulation. The private banks were allowed to issue notes with a minimum denomination initially of $4. The federal government issued smaller notes as well as larger ones used mainly for transactions between banks.

Until the Great Depression of the 1930s there was little need for central banking in a widely scattered and mainly rural economy. With the Depression, various bank scandals and a Conservative Prime Minister’s perceived need for a direct means for settling international accounts, R.B. Bennett set up a royal commission to study “the organisation and working of our entire banking and monetary system [and] to consider the arguments for or against a central banking institution...”

The result was the Bank of Canada Act of 1934. The Bank of Canada began operations in March 1935. It initially was a private corporation with shares sold to the public. The new Liberal government of William Lyons McKenzie King, however, amended the Act and nationalized the institution in 1938. The Bank became publicly owned and remains so today.

The Bank of Canada Act, which defines the Bank’s functions, has been amended many times since 1934. But the preamble to the Act has not changed. The Bank still exists “to regulate credit and currency in the best interests of the economic life of the nation.”

Conflicting definition of the “best interests of the economic life of the nation” between region and metropole played a conspicuous role in the pre-history and constitution of the Federal Reserve Board in the United States. It did and does so still in Canada. The American way is regionalism and local reserves for local investment. Canada, however, chose branch banking in the British tradition. And, unlike the Federal Reserve, the Bank of Canada does not practice regional monetary policy.

The apocryphal “7-to-1” policy of chartered banks in Canada demonstrates its regional animal spirits. For seven dollars in deposits in the regions, one dollar is lent back to local enterprise. In the metropole – Montreal & Toronto – for every dollar deposited seven are lent back to where the opportunities are and the head office with the reserves.

Historic, rather than apocryphal, is the constitutional crisis of 1961 between Governor of the Bank of Canada James Coyne and Conservative Prime Minister John D. Diefenbaker, Member of Parliament for Prince Albert, Saskatchewan - formerly ‘the northwest territories’ of Canada until 1905, a.k.a., the regions. Known as the ‘Coyne Affair’ the Governor publicly criticized the Prime Minister’s expansionist (Keynesian) economic policies especially export sales to the United States during a recession and recommended instead higher interest rates to slow the economy down and eliminate the deficit (Classical).

Behind the national scene, however, were the regional political economic implications of the Governor’s view. Diefenbaker in 1957 created the Agricultural and Rural Development Agency (ARDA) so that federal dollars could help develop the regions outside southern Ontario and Quebec, the metropole. There lived the majority of the population and dollars but not seats in the House of Commons. Diefenbaker’s Conservatives held the regions while his Liberal opposition held the metropole.

The Conservative House of Commons voted to vacate Coyne’s employment but the Liberal dominated Senate refused to pass the bill. Constitutional crisis! Coyne nonetheless resigned. This raises, however, the whole question of the arm’s length relationship. At that time the Bank of Canada was at full arm’s length from government interference. Once appointed the Governor was essentially independent of the Government of the day. Similarly, the Chairman of the Federal Reserve and European Bank are shielded from political interference. They function at full arm’s length. A recent case in Italy where the Governor of the Bank of Italy was accused of interfering with a foreign takeover of an Italian private bank demonstrates. He refused to resign for over five months and only then, I believe, on his terms. As in the Coyne affair, any political interference causes the animal spirits of investors, especially foreign ones, to be depressed. As will be seen, moral suasion is arguably the most powerful tool in the hands of a modern central bank.

Today, after amendment of the Bank of Canada Act, the Minister of Finance can order policy changes. Any minister who does so, however, faces the opprobrium of the investment community with all its economic and political implications.

After the Great Depression of the 1930s tight central banking regulation became the norm at the retail level in the United States, the dominant player and trend setter in banking and financial markets around the world. Among other things the federal government in effect guaranteed retail banking deposits. At the wholesale or investment banking level, however, regulation flowed from security & exchange rather than banking legislation.

In the 1980s deregulation became the policy norm and two major things happened. First, retail banks were allowed to invest their own money, a.k.a., deposits, in ‘secure’ financial securities rather than simply making loans or issuing mortgages. In effect, many became investment banks. Second, financial innovations at the wholesale level rapidly accelerated, among other things, spawning the so-called ‘Masters of the Universe’, a term coined in the 1980s to describe Wall Street brokers in that Age of Greed. Through conglomeration, de-regulation, financial innovation and lax public oversight a ‘shadow banking system’ arose beyond the pale of public scrutiny and arguably beyond accountability becoming, in some cases, ‘too big to fail’.

Ironically, the most recent investment bubble of 2007-8 is rooted in ‘securitization’ intended to spread and minimize risk. According to John R. Commons in his classic Legal Foundations of Capitalism (1924) property, in the economic sense of what can be bought and sold, is the history of its ever increasing intangibility. In this sense, property has become not so much a thing in-and-of-itself but rather an evolving set of rights & obligations associated with it, e.g., a warranty. Thus property today includes intangibles like copyrights on artistic & literary works, patents on inventions, futures options, equity shares, software and investment certificates in land and buildings, e.g., ‘CDOs’ or Collateralized Debt Obligations.

CDOs’are part of a more general and widespread securitization of property. This is done using probability calculations derived from physics and mathematics rather than traditional actuarial calculations. In fact major firms hired high energy particle physicists, mathematicians and economists right out of school to do the calculations. Title is created, as a financial instrument, to a mix of thousands of primary financial instruments such as copyrights, mortgages, patents and student loans. The mix is ‘hedged’ (one primary asset against another so to speak) to assure a mathematically stable rate of return with zero to minimal downside risk. Slices or shares in this consolidated ‘exotic’ (now ‘toxic’) instrument are then offered to investors. Title is granted to a share of the resulting pool.

It is no longer clear, however, what is in any given instrument, e.g.., how much sub-prime, prime or super-prime. Their complexity is such that they are not traded to the general public and therefore not subject to retail security & exchange or banking oversight. Essentially they are sold wholesale between banks, hedge funds and investment houses, intra alia. What is being bought and sold is new exotic and very complicated financial instrument. Their complexity is such that very few understand the math including CEOs of financial institutions buying and selling them. But they have ‘the numbers’. Bond and other rating agencies agreed and initially granted ‘AAA’ ratings to many such securitized financial instruments. The Big Short

In this regard it is critical to note that physics rests on the Laws of Nature while financial investment rests on ever changing human laws and human nature subject to fear and greed. This distinction extends to the application of mathematics. As economist Kenneth Boulding points out there are “limitations [to] mathematics both as a tool and as a language, especially in regard to possible distortions of the growth of knowledge”.

In this regard, the Great Recession of 2008 arguably resulted because of a failure to distinguish between risk and ignorance and between speculation and enterprise. These are the subjects of Chapter 12 – The State of Long-Term Expectations of Keynes’ General Theory of 1936.

Risk involves calculation of the probability of possible outcomes. It implies one knows what those outcomes might be. Usually it also involves setting aside ‘Black Swans’, or outriders of extremely low probability but potentially devastating consequences. With respect to the Great Recession, this was arguably the case with respect to the chance that the entire national housing market in the United States would collapse at the same time. – an extremely low probability but one with devastating consequences.

Ignorance, on the other hand, defined as the lack of knowledge, cannot be subjected to calculation. One just does not know. As Keynes points out in Chapter 12, business enterprise inevitably suffers ignorance beyond a very short time frame. It is animal spirits that keep them going concerns, not probabilistic calculation.

In economics, speculation involves taking risks. And this can be a very good thing, e.g., insurance, future options, etc. It can also be a form of gambling in which short-term trumps long-term returns. In Chapter 12, Keynes compares playing the stock market – day trading - as a beauty contest in which it is not choosing the most beautiful but rather the choosing the one that conventional expectations will choose. This catches the ‘herd mentality’ of equity markets.

Keynes applies “the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life” (Keynes 1936, 158). Arguably, bank deregulation beginning in the 1980s resulted in the merging of the banking and security & exchange systems. Banks traditionally focused on enterprise loaning money (deposits) and retaining ownership of primary financial assets, e.g., the mortgage on a home. With deregulation they began to engage in speculation by selling off primary assets and acquiring secondary or derivative assets, e.g., CODs. With both the banking and security & exchange systems engaged in speculation a financial bubble was arguably inevitable.

FEAR & GREED

The Sub-Prime Bubble & Its Mates

Harry Hillman Chartrand, PhD

Revised March 6, 2008

The most recent investment bubble of 2007-8 is rooted in the 'securitization' of Property. From the perspective of cultural economics Law is not a technical subject but rather a cultural artifact arising from the unique historical experience of a specific culture with its distinctive patterns of custom, habit and life ways (Schlicht 1998). More to the point, each system of Law has its own definition of what can be bought and sold, i.e., What is Property? This contrasts with other things that are not Property especially People.

Today, legal title to Property usually takes the form of a document, deed or certificate establishing the right to possession. The coercive power of the State protects and defends it. There are three forms. There is immovable or ‘real’ Property such as land, buildings and fixtures which together with moveable Property or ‘chattel’ (derived from the Anglo-Saxon for cattle) constitute tangible Property. Then there is intangible Property such as business ‘good will’, stocks, bonds and intellectual property such as copyrights, patents, registered industrial designs and trademarks. Each involves associated rights & obligations granted by and subject to the pleasure of the Sovereign - Crown or State. Each consists of differing bundles of rights & obligations, e.g., the differing term for a patent and a copyright or between allodial, freehold or usufruct (tenant) title to real Property. [1]

John R. Commons observed in his classic Legal Foundations of Capitalism (1924) that Property, in the economic sense of what can be bought and sold, is the history of its ever increasing intangibility. In this sense, Property has become not so much the thing in-and-of-itself but rather an evolving set of rights & obligations associated with it, e.g., a warranty. Thus Property today includes intangibles like artistic & literary works, inventions, futures options, equity shares, software and investment certificates in land and buildings, e.g., ‘CDOs’ or Collateralized Debt Obligations including an unknown number of sub-prime mortgages. Such intangible income earning Property is arguably the legal foundation of the knowledge-based economy (Chartrand 2007). According to Commons, the transition from tangible to intangible Property began in the 1700s with recognition, under Common Law, of business 'goodwill' and copyright as income earning assets. What is bought and sold, in effect, is the expectation of profit, e.g., of a going concern.

'CDOs' are part of a more general and widespread securitization of Property intended to spread and minimize risk. This is done using probability calculations derived from physics and mathematics rather than traditional actuarial calculations. [2] In fact major firms hired high energy particle physicists and mathematicians right out of school to do the calculations. Title is created, as a financial instrument, to a mix of thousands of primary financial instruments such as copyrights, mortgages, patents and even student loans. The mix is 'hedged' (one primary against another so to speak) to assure (mathematically) a stable return with zero to minimal downside risk. Slices or shares in this consolidated 'exotic' (now 'toxic') is then offered to investors. Title is granted as a share in the resulting pool.

As demonstrated in an article by the Economist, "Securitization: Fear and loathing, and a hint of hope" February 14, 2008 it is no longer clear what is in any given instrument, i.e., how much sub-prime, prime or super-prime. Their complexity is such that they are not traded to the general public and therefore not subject to 'retail' security & exchange as well as banking oversight. Essentially they are sold bank to bank, hedge fund to hedge fund, investment house to investment house, intra alia. What is being bought and sold is new exotic and very complicated financial instrument designed to securitize all income earning Property. Their complexity is such that very few understand the math including CEOs of financial institutions buying and selling them. But they have 'the numbers'. The bond and other rating agencies agreed and initially granted 'AAA' ratings to many such securitized financial instruments.

The 'dotcom' bubble of 2001 demonstrated the need for the U.S. Government to regulate the accountancy industry and its clients following the collapse of Arthur Anderson, the fifth largest global accountancy (see the Sarbanes-Oxley Act) . Arguably, the 'sub-prime' bubble demonstrates the need for tighter banking and investment regulation. Why? Simple: Fear & Greed. For whatever reasons investors periodically, throughout capitalist history, come to believe that what goes up does not come down and that the business cycle has ended and there are only blue skies above. This was a theme of the dotcom bubble, i.e., the so-called 'New Economy' based on the internet. When the sky falls the investment community tends to duck for cover in what was called 'a bunker mentality' after the dotcom bubble burst. Fear & Greed are facts of financial life. It is not just cold calculation that motivates investment decision but also raw emotion. Financial loss is right up there with sickness and the emotional loss of a loved one. Financial gain, at the extreme of pure gambling, is arguably as addictive as hard drugs - the rush. Ego deflation and inflation naturally follow. Short-run speculation rather than long-run enterprise too easily becomes the game [3].

Creation of the Bank of Canada in 1935 represented recognition that the financial community could not be trusted to contain its 'animal spirits' and 'excessive exuberance' while Government could not be trusted to keep its hands off the printing press. The Bank represents a new 4th order of Government - executive, legislative, judiciary and central bank. In effect it represents a marriage between Government and Finance in the money market of a capitalist economy. Tight central banking and security & exchange regulation were, until recently, the norm. Recent deregulation arguably went too far and did not kept up with financial innovations trading between 'Masters of the Universe' (a term coined in the 1980s to describe Wall Street brokers in that Age of Greed). Through conglomeration, de-regulation, financial innovation and lax public oversight a 'shadow banking system' has been created beyond the pale of public scrutiny.

Government's role, cum Keynes, is not to inhibit risk taking and financial innovation but to compensate for the bi-polar animal spirits of investors and hence the extremes of the business cycle through 'workable' regulation. This requires, however, recognition on the part of the financial industry itself of a self-felt public responsibility given its privileged status in a capitalist society - noblesse oblige. Arguably there is a generalized need for heightened public accountability and transparency, not just on the part of Government, [4] but also all self-regulating professions, e.g., accountants, architects, engineers, lawyers and physicians. The market works on what Adam Smith called 'moral sentiments' or what today we call ‘market trust'. Trust is a two-way street. And in the current crisis it is lack of trust between banks that is fueling the ongoing problem. In effect we are in an institutional liquidity trap. Interest rates are zero but no one will invest. When one bank is asked to borrow from another, the potential lender looks at a balance sheet that shows securitized assets whose worth cannot be easily determined. Therefore banks will not lend to banks and the entire financial system seized up and its effects are now rippling through the 'real' economy.

Just before the fall of Communism this need for accountability and transparency of all self-regulating agencies of the State including the Party - the leading vanguard of the Revolution - was called perestroika and glasnost. Arguably, the same is needed for the troubled capitalist world order. The 'off loading' of responsibility for the public purpose into semi-public/private hands (the pattern of 'privatization' since the days of Margaret Thatcher, Ronald Reagan and Brian Mulroney), does not relieve Government of responsibility for monitoring and regulating performance. The problem and suggested solutions are presented in my book review of Government by Moonlight - Hybrid Parts of the State (Birkenshaw, P., Harden I. & Lewis, N., Unwin Hyman, London, 1990). For my part, as a Canadian, one possibility is Senate reform inclusive of the self-regulating professions that, through secret ballot, each would elect their own Senator as representative of the profession before the people of Canada.

[1] For a fuller exploration of Property in the Anglosphere please see my recent article "Equity & Aboriginal Title", Compiler Press, January 2008.

[2] It is critical to note that physics rests on the Laws of Nature ewhile financial investment rests on human laws and human nature, both culturally expressed.

[3] This distinction between short-term speculation, e.g., on the stock market, versus long-run expectation of enterprise, i.e., between nominal and real gains, was a central theme of Keynes' analysis of the Great Depression. See Chapter 12 of his General Theory.

[4] For my views on what are the continuing inadequacies of the federal and provincial system of Budget, Estimates and Public Accounts please see: “The 1995-96 Federal Cultural Budget“, Government Information in Canada, University of Saskatchewan, Winter 1995. http://www.usask.ca/library/gic/v2n3/chartrand2/chartrand2.html

Contemporary Economics is rooted in the 17th century Scientific Revolution in England. What we call the natural and engineering sciences were then called ‘experimental philosophy’. This new way of looking at the world gained legitimacy with Charles II’s 1662 Charter to the Royal Society of London for the Improvement of Natural Knowledge. The Scientific Revolution then began in earnest with Isaac Newton’s clockwork universe serving as its icon. This materialistic meme rapidly spread across Europe.

The ascent of experimental philosophy left moral philosophers (those today we call social scientists and humanists) searching for the social equivalent of Newton’s clockwork universe. Arguably it was uncovered by Jeremy Bentham (1748-1832) founder of the last great school of philosophy to emerge from the Western Enlightenment - Utilitarianism.

His answer was the greatest good for the greatest number measured by atomic units of pleasure/pain called utiles with pleasure and pain serving as “sovereign rulers of the State” in Bentham’s words. The greatest good was to be calculated using Bentham’s felicitous calculus, the calculus of human happiness.

While we will consider Bentham’s contribution to economics it is important to note that the impact of his thought was much wider. Thus among his disciples were the Philosophical Radicals who became the Liberal Party of the United Kingdom. They used Bentham’s felicitous calculus to institutionally transform England and its Empire from a feudal into an Administrative State. Their achievements, among others, included: constitutional and local government reform, the end of slavery; responsible government in Canada, universal suffrage; the supremacy of the legislature (or ‘legislative omnicompetence’ in Bentham’s words), compulsory public education, health and safety; penal and criminal law reform including a modern police force; welfare reform; and, founding, in 1826, the first English research university and the first to accept non-Anglican, non-male and non-white students – University College London. These achievements were based on the premise that the happiness of a pauper is equal to that of a prince expressed in the euphemism: An Englishman’s home is his castle. Liberal democracy in fact took root in England through Benthamism dodging the Republicanism of the United States and France.

Bentham’s philosophy is rooted in Epicurean sensationalism. Epicurus (341-271 BCE) was a contemporary of Aristotle and Plato who both believed in the gods but Epicurus did not. Bentham acquired his view from the De Rerum Natura (On the Nature of Things) by the Roman Epicurean poet Lucretius (99-55 BCE), whose work, unlike those of Epicurus, survived the fall of the Roman Empire and the censorial fires of the Church.

Like Epicurus, Bentham believed that physical sensation was the foundation of all knowledge. Knowledge, including preconceptions such as ‘body,’ ‘person,’ ‘usefulness,’ and ‘truth’, form in the material brain as the result of repeated sense-experience of similar objects. Ideas are formed by analogy between or compounding such basic concepts (O’Keefe 2001).

For Bentham sense experiences involved a unit measure of pleasure and pain called the ‘utile’ that eventually, according to Bentham, would be subject to physical measurement. One corollary of the utile, however, is that customs, traditions and taste cease to be independent variables. For Bentham compulsory public education would begin with children taken at birth from their mothers and placed in state-operated crèches. Each child was, Bentham believed, born tabula rasa – blank – and compulsory public education would ensure everyone’s customs, traditions and taste would eventually become identical and therefore irrelevant. He also innovated the Panopticon, an architectural form that allowed the observation of convicts in prison cells (Kingston Penitentiary) is an example and designs for observing the educational life of children and civic life in general by a hidden observer.

Bentham believed that human existence was simply the search for pleasure and the avoidance of pain. Thus utilitarianism is radically materialistic. Even aesthetics shrank to analysis of pleasurable sensations evoked by a work of art. A thing is beautiful because it pleases, it does not please because it is beautiful (Schumpeter 1954, 126-7). This, combined with emphasis on functionality, meant application of artistic effort was “irrational”. In industrial design and architecture, this aesthetic reached its conclusion in the aphorism form follows function, the Bauhaus and the glass and steel towers of the International School of Architecture (Hughes 1981).

In many ways, Bentham makes Karl Marx look like a weak kneed bleeding heart liberal. Marx would have admired John Lennon’s working class hero. Bentham, on the other hand, wanted to socialize not just the means of production but also of consumption. For Bentham the Mao suit or ‘GI’ issue - one size fits all - was the style of the future. It was only the terrors of the French Revolution that drew Bentham back from perfect communism. For Marx, on the other hand, Revolution was the instrument of change. In a sense, Marx was the son that Bentham never had

The formal name for Bentham’s utilitarianism is Ethical Hedonism. The search for pleasure (hedonism) was inhibited in Bentham’s scheme by assuming human beings carried a genetic sense of right and wrong, good and bad - essentially the Protestant work ethic. Once that ethic fades, however, we are left with ‘Me-ism’ socially expressed as ‘Consumerism’.

In 1881 Francis Ysidro Edgeworth (1845-1926) married Bentham’s felicitous calculus of human happiness to Newtonian calculus of motion and reduced it to geometric expression subject to mathematical proof in his Mathematical Psychics. At root this marriage succeeded by using Bentham’s reification (making concrete that which is abstract) of happiness as money – the presence of money brings pleasure, its absence brings pain. One’s willingness to pay $10 for a DVD is a measure of the utility or happiness one hopes to derive from it.

Edgeworth’s geometry and its related calculus permitted erection of what became, in the hands of Alfred Marshall, the Standard Model of Market Economics. It shifted the focus of economics from analysis of the distribution of national wealth among different classes in society to the constrained maximization of utility by consumers generating the Demand Curve and the constrained maximization of producer’s profits generating the Supply Curve with ‘X’ marking the spot where the willingness to buy (Demand) exactly equals the willingness to sell (Supply). The market clears. This is where the greatest good for the greatest number is achieved in the Standard Model of Market Economics.

It is important to note that use of calculus defines the Standard Model as mechanical rather than biological in nature, i.e., the calculus of motion, in this case, of human happiness. It is also important to note that the demand-side of the economic equation came first and flowing from it the supply-side was subsequently erected. Put another way, consumer's wants, needs and desires in the Standard Model precede production of goods & services to satisfy them. This is sometimes called ‘consumer sovereignty’ or ‘dollar democracy’. In this sense the consumer/producer-centred Standard Model of the late 19th century allowed economics to catch up with the citizen/voter-centred Republican Revolution of the 18th century.

It is ironic that Bentham-inspired economics should achieve what Plato most feared about the Arts as expressed in Book X of The Republic:

We must remain firm in our conviction that hymns to the gods and praise of famous men are the only poetry which ought to be admitted into our State. For if you go beyond this and allow honeyed muse to enter, either in epic or lyric verse, not law and the reason of mankind, which by common consent have been ever deemed best, but pleasure and pain will be the rulers in our State.

It is not, however, just the Ancients who have (or would have) concerns about Bentham’s felicitous calculus and the Standard Model. Joseph Schumpeter called it “the shallowest of all conceivable philosophies of life that stands indeed in a position of irreconcilable antagonism to the rest of them” (Schumpeter 1954, 133). John Maynard Keynes went further identifying its dangerous ideological flaws:

I do now regard that as the worm which has been gnawing at the insides of modern civilization and is responsible for its present moral decay. We used to regard the Christians as the enemy, because they appeared as the representatives of tradition, convention and hocus-pocus. In truth, it was the Benthamite calculus, based on an over-valuation of the economic criterion, which was destroying the quality of the popular Ideal. Moreover, it was this escape from Bentham... which has served to protect the whole lot of us from the final reductio ad absurdum of Benthamism known as Marxism (Keynes 1949, 96-7).

In fact, before the Republican Revolutions of the 18th century the economy was embedded in society through guilds and a class structure of subordination by birth. Today, many fear that human society is being embedded into a global economy in which everything is for sale – children, hearts, kidneys, lungs as well as the entire natural and human built environment – as Karl Polanyi suggested in The Great Transformation (2001). Such lingering concerns may be genetic fragments of a not quite dead Marxism or remembrances of forgotten roots - in the United States, “Life, Liberty and the pursuit of Happiness” and in France, “Equality, Fraternity and Liberty”.

In a way, the Republican Revolution overthrew an ancient regime of subordination by birth gaining political freedom for the individual and in the process spawning the free self-regulating market as its economic corollary. The Communist Revolutions of the 20th century, on the other hand, sought economic freedom for the individual (each according to one’s need) through a centrally planned and controlled command economy and spawned the one-party Leninist State as its political corollary. Arguably, both freedoms – political and economic - are necessary, if not sufficient, to fully realize human potential.

Keynes, M., Essays on John Maynard Keynes [1949], Cambridge University Press, Cambridge, 1975.

Schumpeter, J. A., History of Economic Analysis (1954), Oxford University Press, New York, 1968.

For more on Bentham, the 'Marx & Lenin' of Capitalism, please see my MIDAS Lectures: