Has France, Too, Climbed Aboard the Fast Express to Hell?

William Krehm

The New York Times (28/01, "A French Style of Capitalism Is Now Stained" by Nelson D. Schwartz and Jad Mouawad) tells a melancholy tale: "Paris – In a country where the hurly-burly of market capitalism has long been viewed with suspicion, Société Générale was a rare Gallic success story – the Chanel of French banking. The bank pioneered some of the most complex instruments in international finance, earning billions of dollars and the grudging respect of American and British rivals.

"So it was a shock to their national pride when top executives of Société Générale found themselves on the seventh floor of the company’s ultramodern headquarters a week ago Saturday interrogating a 31-year-old trader named Jerome Kerviel and discovering what their innovations had wrought.

"Mr. Kerviel acknowledged placing more than $70 billion in secret, unauthorized derivatives, according to Société Générale, saddling the bank with a $7.2 billion loss, the biggest ever caused by a rogue trader.

"Now the bank, and the broader world of French business, finds itself shamed in the very arena where it had taken pride in being one step ahead of its Anglo-Saxon rivals that dominate financial niches like investment banking and securities underwriting.

"Even worse, Mr. Kerviel took advantage of the very technological sophistication for which the French are known to hide his tracks.

"‘I have to admit this is a massive shock for us,’ said Jean-Pierre Mustier, who as a 26-year-old helped midwife equity derivatives trading in Société Générale in 1987 and is now one of the bank’s top executives as head of the bank’s corporative and investment banking division.

"It was only last May that Christian Noyer, the governor of the Banque de France, the nation’s central bank, promoted the country’s competitive edge in equity derivatives, an arcane universe that allows investors to take risky bets on future moves of stocks or markets. With a 25% global market share, M. Noyer boasted at a banking conference at Mumbai, ‘French expertise in this field is founded on solid teaching in maths, the key to excellence in financial fields, and on an important hive of university-level talents.’"

Against that we must pit the view of John Maynard Keynes not too long before his death in 1946, in questioning econometrics, that tries to deduce what statistics will be saying in the future from what they said in the past. Keynes simply referred to the drastic change produced by the new patterns in economic theory itself. And, of course, since Keynes’s death, the banks have become deregulated and globalized to the point where they have achieved a degree of power that no other group in society can match. This being so, not only econometrics but derivative constructs that mimic the exponential mathematical patterns of the atomic bomb for obligatory ever accelerating growth roil the environment, and reshuffle human relations to an unforeseeable extent. How could this be determined in advance and subjected to risk management? Above all when through the other side of their mouths the officially inspired posit a self-balancing market on which the mathematics of the alleged risk management are based. That it should have caught up with and taken over the lively development among French economists that was taking place in France a few decades ago can be illustrated by my own experiences there at the time. Let me quote from my book Price in a Mixed Economy – Our Record of Disaster (Toronto, 1975, Chapter Four, entitled "The French School of Economics").

Enter Marginal Utility

France was one of the three countries where the theory of marginal utility value theory arose almost simultaneously: France, Britain, and Austria. Adam Smith had used a labour theory as one of his several theories of value to understand the evolving economy of the immediately pre-industrial age. In Britain several decades later David Ricardo had used the labour theory of value to make the case for bringing down the tariffs that buttressed the privileged position of the large landowners, Karl Marx used such a value theory to emphasize the exploitation of labour by the industrial capitalists. John Stuart Mill, whom Marx considered one of the more superficial 19th century economists, actually developed a model that has much appeal to us today – its goal was a "steady state" rather than constant industrial expansion, and included the proper development of humans and care for the environment as an essential part of his goal.

After the barricades that were thrown up across Europe in 1848, the class-warfare had become so menacing that a deep need was felt by those in charge of society for a value theory that would shift the locus of theorizing from the "satanic mills" of the raw industry of the day to the subjective pleasure of the ultimate consumers of the products produced. All this was done with an intimidating use of calculus for those who mistook its use as a guarantee of scientific validity per se. But nothing can be deduced from mathematics.

What is brilliantly possible is to deduce relationships implicit in empirical data by mathematics. Thus utilizing the astronomical observations by Tycho Brahe, John Kepler found that the planets moved in closed orbits, and from that Isaac Newton, applying the binominal theorem he had developed, invented infinitesimal calculus that made it possible for him to discover the law of gravity. However for the marginalist economists the latter 19th century to go on to deduce not by calculus but from calculus that the market was self-balancing made no sense to anybody with the slightest notion of what mathematics can and cannot do.

Because of the realization of this by many French economists after World War II France was a very creative place.

France Becomes Happy Valley of Economic Thinking

I had by then after a wide-ranging journalist experience in Latin America, and what university training I had had in mathematics, plus some business experience, reached the conclusion that the notion of a self-balancing market was unsupportable. I embodied this in a sixty-page essay and sent it to some thirty economic publications throughout the world. It was published in what was then the leading French economic journal in France, La Revue Économique. That opened a world to me that simply had no equivalent in the English-speaking countries. Thus François Perroux, one of the many French economists who questioned the notion of a self-balancing market, wrote of Leon Walras, the French discoverer of the self-balancing market: "It is impossible to speak of a ‘psychology’ of maximization; one can only talk of a rule of maximization of economic life as we are able to observe it, rather it is the polar opposite. At no time in the history of the Western peoples has there been a tendency to eliminate the elements of private power in merchant economy; nor a tendency toward the sovereignty on all markets of price determined by anonymous forces arising in equal measures from the contributions of all participants. General equilibrium is a gymnastic exercise of the mind that reduces the action of people to mechanically organized forces. It is the product of a combination of simple mathematics, distorted observations, and – unconsciously without doubt – an apologetic attitude."

Another French economist of the period, Jean Marchal had written: "In reality the distribution of the national revenue takes place through two series of activities that we shall designate ‘within the structure’ and ‘action upon the structure.’" And that in turn is closely linked to Perroux’s concept of the "dominant revenue": "In turn the dominant revenue has been that of the landowners, then industrial profit, then financial and industrial profits in a mixed economy, in which the rate and mass of profit are functions of a complex combination of public and private, of market and extra-market actions.

"During a specific period of development, the dominant revenue is that one to which the others adapt themselves. In an apologetic doctrine, it is represented as the revenue that, by the rate and mass which it achieves, determines whether the given economy functions properly. In the institutional framework corresponding to the given dominant revenue, that in fact is the case, but in another context it would be otherwise."

Perroux’s Dominant Revenue

"This brings us to the very threshold of the subject of this book. Conventional economic theory is the story of our economy told in terms of the profit of the dominant revenue. Even the revenues of the other factors of production have been revamped and denatured to the idealized logic of the profit motive and presented in marginalist form.

"Jean Marchal views price behaviour from this angle: ‘Price rise has become an integral part of the mechanism of distribution in our modern economy. Today an increase in the monetary revenue of any group does not bring with it a compensating reduction in the revenue of other groups, but a parallel increase.’

"One of the ‘paradoxes’ that have haunted economic reporting in the past decade is the recurrent combination of rising prices and mounting unemployment. By the ground rules of equilibrium theory industrial slack must bring with it declining prices, whereas rising prices are associated with the upward phase of the cycle. Yet this supposed paradox has not been without precedent.... It was observed and documented for several European countries by J.P. Mockers: ‘If this cannot be taken as an absolute general rule, we must, however, state that in most cases observed, the years of economic slack correspond to periods when price increases have been most marked.’

"In some respects French economists have been a decade or two ahead of their English-language colleagues in handling the problem of inflation. As early as 1862 Pierre Biacabe discussed the new structural aspects of price rise as follows: ‘It is necessary either to adopt a new definition of inflation, or to use the term only in its original sense and to find another terminology for the new phenomenon that we are trying to track down. But no one has as yet detected this new phenomenon, and that is because we have no valid theory to grasp the contemporary economic system. Thus we go on calling ‘inflation’ a phenomenon that no longer has the same form, the same object, or the same function as formerly. We continue viewing it as a sinister thing, harmful and destructive, because of the effects it may have had in a previous economic system’ (Analyses contemporaines de l’inflation, Paris, Sirey, 1962, p. 222)."

It was only on reading this that I understood why my 60-page essay, in which I had identified the new structural factor that created the phenomenon of what I called "structural price rise," had been accepted and published by the leading economic journal in France at the time La Revue Économique in their issue of May, 1970. I had quite independently developed the concept that Biacabe had written about 13 years earlier, and identified the missing factor they were seeking.

Unfortunately, today little remains of either the journal or that school of economists. The work of Perroux is next to forgotten. University faculties have been cleansed of all who question that equilibrium theory and misplaced mathematics have made way brutally, and with disastrous results, in the relationship of cultures and nations.

As the world is global and spins incessantly, globalization and deregulation and endless expansion has not only constant perils but dangerous certainties. John Maynard Keynes pointed out the contradiction of a discipline that assumes constant accelerating expansion in a limited space to seek in the statistics of the past a mirror that would provide a picture of the future. As early as May 1993, writing in Economic Reform (April 1992), I noted the ascent of "risk management" supposedly achieved by derivatives: "These abstract mathematical instruments purporting to cut up and quantify the degree of risk – oddly enough guided to a larger extent by the statistics of a more stable, simpler, and less globalized and deregulated world, can hardly provide us with the answers of our ever more expanding, globalizing future." But our obsession with risk management is based on the extent to which we have exposed ourselves to ever greater and omnipresent risk rather than our achievement of convincing methods of managing it. That is why "bankers’ exits" – the banker who puts the "risk management" parcels together seeks to unload them at a profit at the earliest possible moment.

But the magic lure of derivatives – in essence the tug of the exponential curve which is the mathematics of the atomic bomb in such a setting, is irresistible. It is the absolute assurance of ever accelerating growth, which holds the promise mistaken for assurance of mounting profits and options of increasing worth for deserving executives. And this supposed means of predicting the future and its risks is based on past statistics in a world where constant growth and speed up is the basis of the alleged certainties of derivatives.

A Misleading Guide to the Future

John Maynard Keynes made the important distinction between the laws of natural science – physics and chemistry, for example, can be trusted to remain the same, whereas the very Deregulation and Globalization and mandatory speed up in an already overburdened environment change the laws of the environment in which our economies operate at an ever dizzier clip.

Nevertheless just a couple of years ago at a plenary session of a Conference on Heterodox Economics at Cambridge, Keynes’s university, I was unable to extract from three experts on derivatives an answer to my question whether they are for the regulation of the use of derivatives. And yet all three leaders of the discussion were critics of derivatives, and from one of them, J. Kregel, by then in the service of the United Nations, I owed much of my early introduction to the black art of derivatives.

William Krehm

– from Economic Reform, February 2008