What caused the financial collapse?

Here are four causes of the financial crisis not based on conventional economic wisdom:  the way in which we our economy creates money, the using up of the most accessible energy and mineral resources, the greed of most of us and imprudent or fraudulent banking practices which allow bankers to make excessive profits.

For a more conventional explanation see this article in The Economist.

We all use money and many people are very good at “making” money but very few understand its function and how it is created.  As gold and other items have traditionally been used as money we treat it as a commodity with some value of its own.  But money is a tool to facilitate the exchange of goods and services.  It is a token of purchasing power.  It is important that we have just the right amount of money to use otherwise we have inflation (too much money for the transactions we want) or deflation (not enough).

The money we use results from fractional reserve banking in which banks are required to keep a percentage of their deposits as reserves.  How this works is explained in the essay “LETS go to market: Dealing with the crisis” on this weblog.  It is complex but I find it  easy to understand.

Our money supply is based on loans made by banks and upon which they charge interest. For this system to work there must be a continuously increasing supply of money which sort of works so long as the economy is growing.  However, even a slowdown can cause problems because we need the right amount of money for the number of economic transactions.   I think this is a Ponzi scheme and therefore it is bound to collapse.  Periodic financial crises are built into the way we create money.  This is one of the causes of the current crisis.  When the U.S. mortgage bubble burst the money supply and the financial system collapsed.

There are two sides to the economic equation.  One side deals with the financial and the other with the physical goods that provide us with food, shelter, clothing. transportation and toys.

Since the industrial revolution we have been living in unprecedented increasing prosperity.  However there is some evidence that since the 1970s the growth of this prosperity has been slowing down and maybe even declining.  My theory to explain this is that we have used up the most easily accessible of the energy and mineral resources and it now takes more energy to recover what is left.  To use jargon, the marginal costs have increased.  This is bound to affect standards of living as more effort must be applied to resource extraction and less to other things.  This is background to the financial crisis.

Wall Street bankers are the kings of greed who got their riches partly be being in the right place at the right time.  They also make good scapegoats.

A scapegoat is somebody you blame for the consequences of your own weaknesses.  Most if not all of us have some greed and this was a factor in the financial crisis.  Before and since the crisis many people wanted the most they could get.  This includes the savers and investors who wanted the greatest returns to the poorer people who wanted housing they couldn’t afford.  Every time I go to the ATM machine or actually enter the bank I am reminded the financial industry is still appealing to the greed of its customers.

The final cause of the financial crisis is that bankers are smart enough to realize they can increase their margins and make huge profits by mismatching the terms of deposits and loans.  At the best this is imprudent.  It could even be fraud.

Bankers are financial intermediaries in that they collect deposits and make them into loans.  The difference in interest rates provide a margin which covers their expenses and provides some profits.  Prudent banking requires that the terms of the deposits and loans match.  Thus if a banker makes a loan for ten years then he should have on hand ten-year term deposits of the same amount.  Breaking this rule can be very dangerous and very profitable.

The reason for breaking the rule is that the longer the loan the greater the risk and therefore the higher the interest rate which will be charged on the loan and which must be paid to get deposits committed for the same time. A banker who finances a long-term loan with short-term deposits can increase his margin.  Prior to the financial crisis the banks were financing long-term mortgage loans with short-term deposits, some of the deposits were committed just for one day at a time.  This worked well when the economy was going well but when it became apparent there were problems the depositors became worried about their money and refused to roll them over.  As banks are required to only keep a fraction of their deposits on hand there was a limited number of depositors who could be refunded.

I think this should be considered fraud against the depositors or in this case the taxpayers who covered the losses.  It was necessary for the government to step in  because we would have lost even more of our money supply and that would have been disastrous.  The question which probably should not be asked: are bankers continuing to mismatch deposits and loans?

So there you have it, my list of four factors which contributed to the crisis.  All of these will be challenging to change.  Some ideas for change are in my essay “LETS go to market: Dealing with the economic crisis.”

 

If you liked this post your are invited to comment, press the like button and/or click  one of the share buttons. If you disagree you are invited to say why in a comment.  While I like the idea of sharing this platform, my personality is such that I don’t reply to many comments.

Banking, risk, greed and a house of cards

When I took the  course on economics of money and banking,  banks were said to be financial intermediaries which means they act as the facilitator between savers and borrowers.

I thought about this a lot as I read House of Cards by William D. Cohan published by Doubleday in 2009.  It is an account of the history and collapse of Bear Stearns & Co. which was the fifth largest investment bank in the United States.

It appears the two big problems in this bank failure were risk and greed.

When a person borrows money there is some risk that he/she will not be able to repay the loan.  The longer the term of the loan the greater the risk. As interest is in part to allow for risk the longer the term the higher will be the interest rate charged.

The question: Who is going to take the risk? The depositor or the banker?  Whoever takes the risk should also get the interest compensation.

It is clear from this book that the bankers took upon themselves the risk although when the risk became reality  their depositors also lost.  The bankers may not have realized, may not have wanted to realize, the risk they were taking.,

What makes this risk attractive is that short-term interest rates are generally much lower than long-term interest rates.  Therefore a banker can make lots of money by taking short-term deposits with which to make long-term loans.  And this is what Bear Stearns was doing.  A large chunk of the mortgages they were holding in a couple of hedge funds were financed with overnight deposits.  Apparently this was/is a common practice on Wall Street.   There are two risks in doing this: short-term interest rates may move against you or your depositors may  withdraw.

So long as the economy was experiencing economic growth it worked and the bankers made obscene fortunes.  But when economic growth slowed down and it became known that these sub-prime mortgages were not as sound as they had been  promoted, the bankers found that their short-term  lenders refused to re lend the money. Disaster. And these guys had the nerve to whine when it became apparent they were going to lose some of their personal fortune.  They also had to be rescued because banks create money and are too important to let fail.  When Bear Stearns went down there was a lot of worry that the whole financial system would collapse.

One has to note this way of working probably under priced the risks of the sub-prime mortgages and that the investment bankers had a vested interest in doing so.  It made it much easier for them to sell their wares.  If the full risk of the sub-prime mortgages had been charged in interest rates most low-income borrowers would not have been able to afford them. (It is interesting that the U.S. government starting with Clinton encouraged this business by asking the banks to finance  housing for low-income people.)

It is probably safe to say most of these investment bankers were con artists.  However, I would suggest that to have a successful con you must have at least two greedy people.  It is hard to con somebody who is not greedy.

So how do we prevent bankers from taking upon themselves excessive risk?

The first answer is to changed the way in which our economy creates money so that banks are excluded from the process.  For more on this please see the essay LETS go to market: dealing with the economic crisis  on this weblog.

The second thing is to require banks to match the terms of their deposits and loans.  They should make their profits out of the spread between the interest rates they pay and charge. The risks and rewards should go to depositors according to the decisions they make.

The third thing us to require them to publish lots of information about their business.

As for greed, governments should probably not try to legislate. Greedy people should be expected to take the consequences. (Lets make a distinction between cons involving two greedy people and exploitation by a person who has superior strength)

Wall Street has rebounded from this  crisis.  One  has to wonder of any lessons have been learned or are investment bankers still financing long-term loans with short-term deposits.  If so there is potential for another crisis.

Greed, financial crises and regulation

When greed. irrational exuberance or willful misconduct within the financial industry are seen to cause a financial crisis, then we start hearing calls for more regulation as if regulation can control unacceptable human behaviors.

Here’s a theory to explain it all.

Business people, especially financiers,  don’t  like competition and call upon governments to pass legislation which restricts competition.  This allows profits on top of wages and a return on investment.  It also provides opportunities for exploitation.  When the exploitation gets out of hand and becomes obvious or when there is a financial crisis caused by the way in which money is created, then we get calls for more regulation.

The best way to deal with greed and willful misconduct is probably to increase competition by repealing legislation which restricts competition.  The way to deal with financial crises is to change the way in which we create money.

Dealing with financial greed

Wall Street greed is one of many explanations being offered for the economic crisis.  To the extent that greed is a part of the problem I think it is the greed of most of us that counts.

Most of us have wanted the highest possible returns on our savings and at least as many mechanical and/or electronic toys as our neighbors.  In this respect the 99 per cent are little different from the one percent.

On top of this so many people appear to be ignorant about financial matters and feel they have no option but to trust an expert such as a financial adviser or a bank manager.

Greed plus ignorance makes one the ideal victim for a scam.

Having said all that I would draw your attention to this column from the Washington Post titled “10 inviolable rules for dealing with the sharks on Wall Street”

The column was directed at people with firms or organizations dealing with Wall Street.  But it seems like good advice for any one dealing with the financial industry at any level either as a borrower or a lender.

Financial innovations and hiding the risks

This weeks Economist has a feature and an editorial on financial innovation which got my mind going.

Financial intermediation is to act as the intermediary between savers and those who would use the savings.  It allows large projects to go ahead.

It also involves risk.  One is the risk of inflation and the other is the risk that the user of the savings will make unsatisfactory decisions which result in loss.  When you allow somebody else to make decisions involving your money  in most cases their interests will come before yours.

Can we really expect regulators to protect us from our own greed as well as the greed of those who work in the financial industry?

It may be that financial innovations work to hide the risk – from the original savers and most of the people working in the industry.  So long as things are going well innovations will work to hide the risks but when something goes wrong somebody will have to take the losses and those somebodies will probably be the original savers.

Wall Street protesters and greed

One has to have a lot of sympathy for all those young people whose future is looking somewhat bleak and also with those middle age folks who have lost their jobs and sometimes their homes and all those who are suffering from the economic downturn.  However making Wall Street workers into scapegoats isn’t going to accomplish much other than allowing people to express their frustrations.

Wall Street people may be greedy but their main crime is to be more successful at being greedy than everyone else. Most of us have sought the good life and we have willingly gone along with investment salesmen who have promised high returns.  If the rest of had not been so greedy the people of Wall Street would not have been so successful.

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