Table 1

1
Table 1 The Evolution of Production and Its
Organization





Economy
Ownership/Control
Production Method
Purpose
Scope
Production for use
Handicrafthand tools
Money
Proprietor/Partner
Local/Regional
P/P Manager gt joint stock company
Production for sale
Regional/National
Factory Machines
Money gt Credit
Industrial Machine Process
National/ International
StockholderAbsentee Owner/ Managerial
Credit (Mark I)
Capital gains
Technological Electronic Machine Process
StockholderAbsentee Owner/ Managerial Elite
Credit Derivatives (Mark II)
Asset Value Manipulation
Anational
2

• Financial Instability
• Stability breeds instability
• Stability leads to comfort and belief that risk
  is less (example US housing market 1975- 1995)
• Expected future income of firm (example,
  expected 6 average annual increase in US housing
  prices, used in ratings models)
• Income of firm realized vs speculative

3
Business Fluctuations - Theories

• Production Cycles
• Marx simple underconsumption
• Schumpeter innovation and increased investment
• End of investment opportunities
• Lack of creative destruction due to growing firm
  size and inflexibility
• Monetary Credit Cycles
• Keynes -- Both production and Monetary complex
  underconsumption
• Veblen -- speculation and credit cycles
• Minsky financial instability hypothesis will
  not go into this-- similar to Veblen in some
  significant ways

4

• Keynes Theory of Employment Money - and
  Institutional theory
• Fluctuations in economy due to Aggregates not
  individuals
• Under investment underconsumption theory of
  the trade cycle
• Long term involuntary unemployment
• Solution
• Government Borrow and Spend
• Consequences
• Deficit finance functional finance
• Balanced budget becomes part of mythology
• Saving is function of income not interest rate
• Changes the concept of necessity to raise
  interest rate and other incentives to save
• Capital (physical) accumulation theory of
  classical theory obsolete (savings centered
  theory)
• Replaced by knowledge and resource based theory
• Resources are a function of knowledge and Become
  . . . Not are
• Scarcity as social condition transcends scarcity
  as natural one

5
     

• To Repeat Institutionalization of intangible
  property strengthens instability of financial
  systems offsetting in part some of the gains of
  previous institutional changes
• Example
• A primer on modern housing Institutional
  Evolution
• Securities, Equity- Debt, from these all else is
  derived. The innovations in finance are few,
  just new names for the same things. We add
  Insurance as a socialization of risk of damage
• It has several traits
• Market Value (MV) selling price also
  Collateral value
• A Book Value (BV) replacement cost
• Debt Mortgage Balance (MB)
• Equity MV - MB
• MV gt BV asset appreciation
• BV lt MV asset depreciation

6

• AS a hedge against MV lt MB we developed and
  expanded several institutions and organizations
• Down payment, a monetary amount of some
  percentage of the sales price (MVt), 20 percent
  in the early years then less later Less than 20
  usually required mortgage insurance
• Income assurance, rigorous proof of income,
  employment, etc. (mp 29 of GAI)
• Credit rating, a number reflecting an evaluation
  of the borrowers credit history.
• 4. Enabling Organizations
• Local Savings and Loans Thrifts
• Capital Federal Savings Loan
• Argentine Saving Loan
• Lincoln National
• Federal Mortgage Mortgage Assurance
  Institutions
• Freddie Mac 1970 secondary mortgage loan
  market
• Fannie Mae 1938 national secondary mortgage
  less reliance on thrifts
• Securitization of mortgages
• VA loans 1944 18 million loans
• FHA Federal Mortgage Insurance 1934 34
  million loans

7

• There were ancillary institutions and
  organizations
• Financial Regulation Interstate or Branch
  Banking Banned
• Separation of Commercial Banking from
  Investment Banking (Glass-Steagall Act)
• Third Party (Independent) Credit Rating
  Agencies
• Investment Activity gtdominatedgt Trading
  Activity
• The led to a US housing market and housing that
  was the envy of the world

8
Number of Housing Units Built in US, by Selected
years, 1919 and before to 2009
Table 2-1. Introductory Characteristics--Occupied Units      
Numbers in thousands.      
Characteristics Total occupied units Tenure Tenure
Characteristics Total occupied units Owner Renter
       
       
Total 111,806 76,428 35,378
       
Year Structure Built3, 5      
       
2005 to 2009 5,884 4,601 1,283
2000 to 2004 8,102 6,371 1,731
1995 to 1999 7,825 6,221 1,603
1990 to 1994 5,995 4,715 1,280
1985 to 1989 7,648 5,159 2,489
1980 to 1984 6,380 4,201 2,179
1975 to 1979 11,835 7,471 4,364
1970 to 1974 9,413 5,696 3,718
1960 to 1969 13,326 8,917 4,409
1950 to 1959 11,771 8,528 3,243
1940 to 1949 6,745 4,423 2,322
1930 to 1939 4,828 2,904 1,924
1920 to 1929 4,331 2,520 1,811
1919 or earlier 7,724 4,703 3,021
Median 1974 1975 1971
   
       

• But a House is more than a place to live, it is
  also an asset, a source of equity and debt.

9

• Then comes a retrenchment to the old habits
• A belief in the ever expanding housing market
  and home prices
• Belief in self-regulating markets to deliver on
  their utopian promise
• An ideological power structure to assist in
  removing or forestalling regulatory forces
• Trading as a dominant process for earning it
• SPEED, trading at the speed of light 24 hours per
  day
• This led to

• Savings Loan Industry Deregulated 1981 now
  can engage in banking activity
• Financial Regulation Interstate Banking Ban
  repealed 1984
• Separation of Commercial from Investment Banking
  (Glass-Steagall Act) repealed 1995
• Third Party (Independent) Credit Rating Agencies
  compromised
• Investment Activity gt morphs to gtTrading Activity
  after dot com bubble burst
• One consequence was a spawning of new or
  repackaged investment instruments in the image of
  Goldman Sachs Trading Company of 1929.
• An example

10
Credit Default Swap 1 (CDS) Playing short for
the CDO price to go down or to fail (default)
this is roughly equivalent to buying a fire
insurance policy on your house with a value
greater than MV and then hiring someone to set it
on fire. If the CDO goes down, you gain because
the CDS (insurance) pays out at the price of the
CDO at the time you bought the CDS (the insured
amount). CDS 2 long playing for the CDO
price to go up or not to fail (not default)
this is roughly equivalent to buying a fire
insurance policy on your house for less than the
MV then paying someone to stand watch with a fire
hose. One could buy any combination of the
derivatives, CDO (MBS is one) and CDSs Now
suppose we have an important investment company
seeking ratings for instruments that it wants to
sell. It uses that position to persuade the
rating agency that the instrument is worthy of a
high rating.
11
Making Collateralized Debt Obligations Mortgage
Backed Securities Simple Tranche
Beginning Portfolio of Mortgages
Collateralized Debt Obligation Low Risk Fund Name
Beta 1
Collateralized Debt Obligation Medium Risk
Fund Name Junk 1
Collateralized Debt Obligation Risky Fund Name
Default 1
Collateralized Debt Obligation High Risk
Fund Name Toxic 1
Collateralized Debt Obligation Lowest Risk
Fund Name Alpha 1
Rating AAA
Rating BBB
Rating NA Not For Sale
Rating DDD
Rating CCC
These may be rated by a third party and sold
based on that rating. The higher the rating the
lower the risk and hence the lower the return.
Investors may choose the level of risk and return
based on the rating and the transparency of the
collateral behind the debt. Also, and this is
one purpose for these securities, an investor may
choose the timing of their income from the
tranche they buy.
Fair enough, but now the fun starts. We move on
to create a Synthetic CDO
12
Making Collateralized Debt Obligations
Synthetic Tranche
Alpha 1
Beta 1
Junk 1
Default 1
Toxic 1
Surplus Toxins
Rating AAA
Rating BBB
Rating DDD
Rating AAA
Rating BBB
Rating AAA
We can create many combinations of financial
instruments based on the previous portfolios.
With a AAA rating these can be sold to
organizations required to buy only AAA securities.
On the theory that several toxic assets in a
portfolio are less risky than one of them we
create another CDO and rerate it
higher. Especially if we can buy insurance and
play it short then we may get a higher rating
13
Goldman Sachs went public in 1999 In 1998 72
of its net income came from investment banking
asset management services In 2009 76 came
from trading and the remainder from Investment
banking asset management services
14
SEC civil fraud lawsuit, filed in April 2010
Abacus mortgage-backed CDOs On April 16, 2010,
the Securities and Exchange Commission (SEC)
announced that it was suing Goldman Sachs and one
of its employees, The SEC alleged that Goldman
misstated and omitted facts in disclosure
documents for a synthetic CDO product it called
Abacus 2007. The allegation is that Goldman
misrepresented to investors that an independent
selection agent, ACA, had reviewed the mortgage
package underlying the credit default
obligations, and that Goldman failed to disclose
to ACA that a hedge fund, Paulson Co, that
sought to short the package, had helped select
underlying mortgages for the package against
which it planned to bet. The complaint states
that Paulson made a 1 billion profit from the
short investments CDSs, while purchasers of the
materials lost the same amount. The two main
investors who lost money were ABN Amro and IKB
Deutche Industriebank. IKB lost 150,000,000
within months on the purchase. ABN Amro lost
840,909,090. Goldman stated the firm also lost
90 million and did not structure a portfolio
that was designed to lose money The New York
Times reported that After the SEC announced the
suit during the April 16, 2010 trading day,
Goldman's Sachs's stock fell 13 to close at
160.70 from 184.27 on volume of over 102,000,000
shares (vs. a 52 week average of 13,000,000
shares). The firm's shares lost 10 billion in
market value during the trading session. On April
30, 2010, shares tumbled further on news that the
Manhattan office of the US Attorney General
launched a criminal probe into Goldman Sachs,
sending the stock down more than 15 points, or
nearly ten percent to 145.
15
Goldman Sachs Stock Price 2003-2011

16
New Theories

• New Institutional Economics
• Coase Nature of Firm (why are there firms)
• Transactions Costs
• Substitution at the Margin labor/capital
  production function
• Simon
• Not firms that are explained by markets --
  Rather Markets are explained by firms
• Organizational Capitalism
• Williamson
• Limited Information (Bounded Rationality of
  Simon)
• Opportunism
• Self interest with guile
• Asset Specificity Make/Buy
• Penrose -- a Veblenian Update
• Everything can not happen at once
• A person can not do everything/anything alone
• The Learning firm
• Can not buy inputs the way the firms uses them
  labor
• Objective Knowledge -- transferable via books,
  manuals
• Experiential Knowledge

17
Path Analysis

• Veblen
• British Rail System in 1914
• The mud hole metaphor more on this later
• David
• Clio and the Economics of QWERTY 1985
• Keyboard configuration
• Technological Lock-in
• Why the nature of a path
• Ergodic
• Non-ergodic
• Small events early in a technology

18
Path continued

• Arthur
• Non-linear probability 1991
• Example of rings in an urn
• Draw a sample and replace with color bias
• What happens
• no stable equilibrium
• No necessity to pick better technology
• VHS Beta
• Increasing returns problem
• Possible solution Positive feedback
• Standard approach is negative feedback system
• Firm and industry location
• Carpet firms in Georgia why there?
• Third Italy history of institutions and
  institutional adjustment
• Complexity theory

19
Path Dependence A Story and a Metaphor

• The Reivers

20
From Faulkners The Reivers There was something
dreamlike about it. Not night-marish just
dreamlike--the peaceful, quiet remote, sylvan,
almost primeval setting of ooze and slime and
jungle growth . . . In it the expensive useless
mechanical toy rated in power and strength by the
dozens of horses, yet held helpless and impotent
in the almost infantile clutch of a few inches of
the temporary confederation of two mild and
pacific elementsearth and water . . . the
three of us, . . . now unrecognizable mud-colored
creatures engaged in a life-and-death struggle
with it, . . . And all the while, the man sat in
his tilted chair on the gallery watching us while
Ned and I stained for every inch . . . and Boon .
. . strove like a demon, titanic, . . . lifting
and heaving it forward . . . he dropped, flung
away his pole. . . How much do you have to pay
him to get dug out? Ned asked. Two dollars,
Boon said. Two dollars? Ned said. This
sho beats cotton. He can farm right here setting
in the shade without even moving. What I wants
Boss to get me is a well-traveled mudhole.
Morning, boys, he said. Looks like youre
about ready for me now. Looks like it, Boon
said. . . . We might a got through . . . if you
folks didnt raise such heavy mud up
here. Dont hold that against us, the man
said. Muds one of our best crops up
thisaway. At two dollars a mudhole, it ought to
be your best, Ned said. That was last year,
the man said. Its double now. Its six
dollars, he said. I charge a dollar a
passenger. There was two of you last year. That
was two dollars. The price is doubled now.
Theres three of you. Thats six dollars Boon
said, Suppose I dont pay you six dollars.
Suppose I dont pay you nothing. You can do
that too, the man said. . . . . Maybe youd
rather walk back to Jefferson than pay two
dollars. (Faulkner, pp. 80-91)
21

• Roads, Cars Mud holes
• Evolution of Roads, Cars
• And the Economy becomes dependent on single
  source variable route individual transportation
  system
• GM plan
• Economies are both path dependent and path
  created
• Depends on structure, function and flexibility
• Flexibility is inversely related to strength of
  tradition
• Myth, legend and invidious differential advantage
• Strength of status quo
• Flexibility is directly related to strength of
  learning and growth of community shared knowledge
• Technology
• Education
• Objective and Experiential knowledge (the
  interaction of knowing doing)

22
Mud Puddles Mud Holes Quagmires
Wooden baseball bats Typewriter Keyboards Cities located in flood plains
VHS videotapes Computer Operating systems Cities located in deserts
File name extension OPEC and Exxon Railroad gauge
Y2K bug National brand beer Automobile dominated transportation
Language homonyms Sport Utility Vehicles Pecuniary dominated industrial apparatus
23
Examples of Feedback Attributes
Instrumental Ceremonial
associative territorial
deliberation calculation
technical skill invidious comparison
means-end-means expediency
inventiveness appearance
honesty deceit
adaptive inflexible
democratic autocratic
confidence anxiety
creativeness credit conscious
innovation opportunism
participatory proprietary
imaginative guileful
cooperative competitive
generosity selfishness
decency meanness
forgiveness revenge