Table 1 The Evolution of Production and Its Organization

1. Table 1 The Evolution of Production and Its Organization Production Method Economy Ownership/Control Purpose Scope Production for use Handicraft–hand tools Money Proprietor/Partner Local/Regional P/P Manager > joint stock company Production for sale Regional/National Factory – Machines Money > Credit Industrial – Machine Process National/ International Stockholder–Absentee Owner/ Managerial Credit (Mark I) Capital gains Technological – Electronic Machine Process Credit– Derivatives (Mark II) Stockholder–Absentee Owner/ Managerial Elite 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 > BV = asset appreciation BV < MV = asset depreciation If MV > MB then positive equity If MV < MB then negative equity

6. AS a hedge against MV < 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 • HUD – 1965 • Consumer credit rating – credit bureau

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 >dominated> 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 • 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 > morphs to >Trading 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 CDS’s 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 A A A A B B C C C C B B D D D D F F F F F A A A A A A B B B B C C C C C C D D D D D D F F F F B B F F 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 = CCC Rating = DDD Rating = NA Not For Sale 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 A A B C C B D D F F F F F F F A A A B B C C C D D D F F F F B F F Alpha 1 Beta 1 Junk 1 Default 1 Toxic 1 Surplus Toxins Rating = AAA Rating = DDD Rating = AAA Rating = BBB 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 CDS’s, 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 • embedded in habits skills, routines – can not be transmitted via books or manuals only through working together • People must learn to work together • Planning firm requires cooperation of many individuals

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 Faulkner’s 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 elements—earth 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 you’re about ready for me now.: “Looks like it, “ Boon said. . . . “We might a got through . . . if you folks didn’t raise such heavy mud up here.” “Don’t hold that against us,” the man said. “Mud’s 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. “It’s double now.” “It’s 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. There’s three of you. That’s six dollars Boon said, “Suppose I don’t pay you six dollars. Suppose I don’t pay you nothing.” “You can do that too,” the man said. “ . . . . Maybe you’d 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)

23. Examples of Feedback Attributes