I am borrowing from a post of mine that should be a thread. For me, this is the biggest lesson learned from the global economic crisis of the last four years. With the understanding that I idolized Reagan and was a devout disciple of supply-side economics, it seems clear to me that the Republican economic platform has failed fundamentally. The basis for the Republican's philosophy today, and the management of the Federal Reserve since Reagan, can be traced directly to Ayn Rand. Greenspan was Rand's star pupil and Reagans economic wizard. He managed the Federal reserve from 1987-2006. http://en.wikipedia.org/wiki/Alan_Greenspan It seems to me that the real Achilles heel here in practice, the reason we couldn't allow market discipline to run its course, is the problem of "too big to fail". While free markets probably still work, we can't afford to live with the market corrections! In order to prevent another global calamity like the one that we've just seen, financial markets must be strictly regulated. This completely undermines the foundational argument that government just gets in the way. In fact, if left to run amok, we now know that free markets can destroy the global economy. That pretty much cinches the argument for me. I still believe in the principle of free markets, but it is clear that markets cannot be completely free. Less regulation is not always better, and market discipline is unreliable. This profoundly changes the debate between the left and right. From my point of view, until Republicans acknowledge this fundamental failure of the free market and adopt a modified position, there is no credible right. They are in denial. Frontline ran some great summary documentaries of the events leading up to the crisis, as told by insiders. Inside the Meltdown Main Page http://www.pbs.org/wgbh/pages/frontline/meltdown/ Program http://www.pbs.org/wgbh/pages/frontline/meltdown/view/ The Warning http://www.pbs.org/wgbh/pages/frontline/warning/view/?autoplay There is another good Frontline on this subject that I haven't found yet.
Just as an initial aside, you can't prove much relying on Alan Greenspan's particular beliefs (because it's an appeal to authority, so rather like trying to disprove quantum theory by pointing out that Einstein, who helped form it in the early 20th century, ultimately rejected it). Greenspan could (in theory) have been right that markets are over-regulated and wrong to later retreat from that position. With that out of the way, there really aren't that many people who favor a purely laissez-faire system. The real debate is over the degree of regulation for the most part. There are a few true anarcho-capitalists in the world (and there have been intellectually respectable ones, like Murray Rothbard), but otherwise even most hardcore Austrians believe that there needs to be a court system that will penalize people for things like fraud or infringement of another's property interests (which in turn requires the government to regulate "property" enough to delineate who has which rights). Even Greenspan wasn't fully laissez-faire (and if he were then chairing the Fed is a crazy way to further that commitment, given the Fed's involvement as the American central bank). The truth is that no nation in recorded history has ever had anything even close to a laissez-faire system. Greenspan wanted to dismantle a great many regulations, in theory, but that was outside the purview of the Fed. I'm sure in his heyday, he'd have wanted the Comptroller of the Currency (regulating national banks), OTS, NCUA, SEC, CFTC, EPA, FTC, FDA and many other economic regulators either entirely dismantled or incredibly scaled back in their regulatory and rule-making authority...but they existed and operated throughout his tenure. Still, if you have rejected a pure laissez-faire system, I agree wioth you (as most people do)...the real question is how much regulation do you want? There are positions available that range from "none" to "iron-fisted central planning by a single man in far off Washington". Obviously, almost everyone is far away from either pole. People are inconsistent in their beliefs though, so that he changed his mind, then tempered his change of heart isn't surprising. The good news is that the recession ended back in 2009. The crisis is over. If we really were the good Keynesians some people claim to be, we would no longer be running deficits now...we'd be preparing for the next recession by running a government surplus, so we'll have cash to spend during the next bust.
Well that is not true, as there is the little matter of full employment. When the economy reaches full employment, then you are right. Keynesians would then prescribe paying down the deficit/fiscal austerity and contractionary monetary policies and preparing for the next recession. But we are not yet at full employment.
The latest catastrophe was a long time coming, and may end with larger county/municipal dynamics holding sovereignty over remote areas (those areas with little funds to continue local needed government services) , with "internet connectivity" a major factor in its possible success. In a long time coming, I mean in the "inevitable conclusion" to Western U.S. migration "Land Poor**" dynamics: 1)Pioneer families secure deeds in vast expanses of "fair clime" western beach properties. 2)As time progresses, these properties become stressed to remain low in taxes as designated "farmland". 3)These family landowners developed some of these properties into sell-able plots, which are innocently, modestly priced by them...outrageously modest for the surrounding market's current dynamics. 4)Properties are sold, and immediately put back on the market at huge mark-ups by the lucky new owners, to reflect the current surrounding-area housing and bare property values. 5)These quick profits drive prices even further. These are, ironically, the same old dynamics that drew marriages of land poor tribal families of England, to families of burgeoning "new money" industrial revolution. Monkey wrenches lying about to wreak havoc in any long-term economic planning strategy. **-Land Poor, as defined as to have access through inheritances, or through homestead instances, the ownership of great expanses of property, without the presence of capital or other wealth to maintain or sustain those properties in perpetuity.
I wasn't appealing to authority. Greenspan played a large role in guiding economic policy since Ford. But more importantly, the Republican party still appeals to the same ideology without recognition of the failure. If you listen to Republican pundits and politicians, you would think this was all caused by helping poor people get into homes. It is spun as being caused by regulation, not a lack of it. It was the Democrat's fault! And Ron Paul Libertarians certainly haven't gotten the message. Paul still gets big cheers from the Republican crowds. Beyond the pure Rand philosophy, which can now be soundly rejected based on evidence, I think you missed a major point wrt to the OTC derivatives markets. In essence, that was a covert attempt at laissez-faire capitalism. One might almost suspect that this was Greenspan's way of bringing his pure libertarian philosophy to the mainstream. And not only was the derivatives market unregulated, it was dark. So this dark market, worth hundreds of trillions, was about as close to laissez-faire capitalism as one can get. And OTC derivatives were at the heart of the crisis. In 2008 - http://www.bis.org/press/p081113.htm Emphasis mine. The last time I checked, and according to Brooksley Born at the time of her interview, the markets were still vulnerable. And according to her, the crises will continue until these dark markets are properly regulated.
The notional amount of derivatives contracts tell you almost nothing about the contracts. That is not the amount at risk, it's just a reference amount that is used to make calculations in the agreement (hence it's "notional" as in "conceptual rather than real"). Derivatives are simply private agreements. If derivatives contracts must be regulated, what about every other agreement humans make? Are you concerned that they are also generally unreported? What actually needed reporting was the systematic and undiversifiable risk that institutions were taking, but otherwise fear of derivatives is mostly a bogeyman of those not familiar with economics. Even cash is a derivative, economically speaking. It's value is not intrinsic to itself, but is derived (hence the term) from the value of goods and services it can be traded for. It is quite literally an "option" (used in a sense no different from the way the term is used in option markets) to acquire goods or services on a later date. If we didn't have "too big to fail" companies, there would be no reason to worry about derivatives at all. The problem with them is not that they are bad in and of themselves, but rather if certain companies use them unwisely, then the government would bail out those companies to prevent ripple effects...but when you do that you encourage those companies to use derivatives unwisely, because the upside is huge, and the downside limited because of the bail out. In any event, derivatives are purely financial instruments. No goods are made as a result of those contracts, no pollutants emitted, no workers hired, no discrimination against disfavored groups. All derivatives derive their value from the value of other, actual and not notional, assets. That derivatives as a whole faced limited (though not "no") regulation hardly makes a strong case for the existence of a "laissez faire" regime, especially when the various economic components from which they derived their value (like commercial lending and commodities production) were heavily regulated.
Agreed Ok now you are stretching it. First, private agreements are regulated. It's called the Uniform Commercial Code. Cash as a derivative? That is a big stretch too. The value of a derivative is dependent upon the value of an underlying security. The value of the dollar is only dependent on what an individual or an institution is willing to pay for it. The danger in derivative trading (e.g. The Great Recession) is that they represent an unreported liability to the banking industry. When information is not complete or wrong, it skews pricing and makes markets inefficient. And as we have recently witnessed this hidden liability has the potential to cause a massive liquidity crisis that endangers not only the bank stockholders but it's depositors as well. Risk is why banks were regulated and precisely why they must continue to be regulated wither they are too big to fail or not. Why did "too big to fail" institutions arise? Because there was a need for better pricing - more efficiency. What is the difference between having a few versus many? The issue is risk, not the size of the institutions. There is nothing wrong with risk either, as long as it is properly managed. And in the case of The Great Recession, it clearly was not well managed. Government has been bailing out large and small banks for almost a hundred years. When banks fail the government closes them down and resells them in an orderly process that protects depositors and creditors. Dodd-Frank now provides a framework for dismantling "too big to fail" institutions. So in the future "too big to fail" institutions will be dismantled show they manage to take on too much risk despite the new oversight provided by banking re-regulation. http://banking.senate.gov/public/_f...Street_Reform_comprehensive_summary_Final.pdf Yes derivatives are purely financial instruments that represent a potential liability/risk to the parties involved. If you are a bank or insurance company risk gone wild can kill your organization and those that do business with you as well, including your customers and depositors. Risk management gone wild is what we saw with deregulation of the banking industry at the turn of the century. The underlying industry is not the issue with derivatives it is the liability those securities represent to the parties who own the derivatives and bear the risk associated with these financial instruments. So wither the underlying industries are regulated or not is really not material.
Which covers only gontracts for the sale of goods, and eseentially just replaces the common law of contracts. All contracts, includding derivatives contracts are governed (and "regulated" in that sense) by contract law. The economics are clear, a "derivative" is not based solely on the value of a security...you can (and people do have derivatives of plain old contracts (which is what a credit default swap is, even though there is usually no underlying security there at all. What people will pay for cash, as you put it is derived from the value of what they can trade it for. An option agreement is a derivative and one could say that it's value is "what people in the options market are willing to pay for it", but what people are willing to pay in based ion the underlying asset that option relates to...in other words people value the option based on what the option can be traded for in the future. Cash is no different. Economically speaking cash is an option, it is an option to purchase unspecified goods in the future in a single transaction. With a typical financial option you can (nominally) only trade it for one particular good (usually a security), but you can also trade it in a series of transactions for other goods based on its current market value. The same economics apply to both, and the same economics apply to an option to extend the contract of sports figure or any other option based on future events. The only difference is that financial options and cash are incredibly liquid, and that financial options tend to be used by companies that fall into the too big to fail category (so derivatives defaults led to unanticipated problems in 2007 and 2008). Again I have no issue regulating banks that get to be too big, and some degree of regulation of all banks is prudent...but that doesn't suggest that derivatives should be demonized as part of some secret laissez-faire enthusiast conspiracy. Banking regulators should emphasize more disclosure of derivatives positions in financial statements and be certain that institutions trading huge derivatives portfolios have adequate capital (though not under the current "but never ever use that reserve capital" system, imo). I think it would also be good for banks to use more sound risk-management strategies than they were...though I am not convinced that a government regulator will be all that good at bringing that about. More likely a regulator will set an arbitrary limit on the use of disfavored instruments because (most likely) the regulator won't really understand them, and so need a simple, if inefficient, rule to have any hope of policing the market. If it were me, I'd issue guidelines that banks with substantial trading or derivatives activity that include: active senior management oversight of trading activities; establishment of an internal risk-management assessment that is independent of the trading function; outside audits to identify internal control weaknesses; and risk-measurement and risk-management information systems that include stress tests, simulations, and contingency plans for adverse market movements. Once you take care of the "too big to fail" problem (and likely readdress the issue of deposit insurance, as that dissuades customers from caring about how much risk banks carry), an adequately informed market can police the risk management stance adopted by a given bank. It can then be the responsibility of a bank's senior management to ensure that risks are effectively controlled and limited to levels that do not pose a serious threat to its capital position. Regulation will never be an effective substitute for sound risk management at the level of an individual company. Not in the last round they didn't. We will see if the practice lives up to the theory "Purely financial" is a confusing characterization given their prevalent use in hedging practical business and commodity risks. Airlines use derivatives to hedge the risk that jet fuel prices will increase, for example, so that the price of our plane tickets doesn't swing wildly from week to week. Insurance is not federally regulated even today, other than in a relatively few minor ways. The feds are still "studying that problem" at the federal level, though the recently delayed report on the matter should be out in a few months. Insurance has always been regulated by the States (though that could change). To be clear too, "de-regulation" of the banks really meant "relatively less regulation. It's not as if they were unregulatied. Banks are regulated by the States, the FDIC, OCC, the OTC, the Treasury generally and to some degree by the Fed (though usually in a more indirect way, though discount operations). I personally believe that federal deposit insurance has limited the risks of a bank panics but eliminated any sense of people caring what risks their banks are taking. That was not always the case. Pre-FDIC, many people were concerned about the possibility of bank failure and moved their deposits if they felt an institution was unsafe. Taken to an extreme, that's what a bank panic is. To avoid the panics, we've successfully ended any sense of consumers watching over the banks that hold consumer deposits, the credit risk of the bank itself is not very relevant to the typical depositor now. It's not surprising from that perspective that result was "Hey the banks are taking more risks."
True, that is my point. Government already regulates commercial contracts. It is a necessary foundation for successful commerce. The value of the derivative is based on some aspect or attribute or right bestowed on the owner related to an underlying security (e.g. futures contracts, credit default swaps, etc). Derivatives are all about risk. Yeah, I saw where you were going with cash as a derivative the first time. And I still think you are stretching it. Cash/currency is an asset like any other asset or commodity (e.g. gold, silver, etc.). Using your very broad definition gold, silver or oil and any other asset would be considered a derivative as well. I don't think derivatives are being demonized. I think what is being demonized and rightly so is the misuse and mismanagement of derivative contracts. That is essentially what Dodd-Frank does. Government regulators did a fairly good job of bank regulation for the lasts 80 years. I don't see why that should suddenly change. Is not that what bank management was supposed to be doing prior to The Great Recession? It didn't work. "Too big to fail" has been taken care of with Dodd-Frank. You think bank customers have the ability to go through bank financial statements and disclosures and make informed decisions about bank risk? I don't think Joe burger flipper or Nancy carpenter has the knowledge, desire or ability to make those kind of assessments. Bank senior management was supposed to be overseeing risk this last time around, and greed trumped responsible behavior yet again. It has been for the last 80 years. Since Glass-Stegal and the many other bank regulations banks have become very stable over the course of the last 80 years. The exception being our last 10 year period of instability brought about by a partial deregulation of the industry and the nations gambling laws. They had a global crisis in 2008 brought about by a partial deregulation of the industry. The solution is not more deregulation but re-regulation and a restoration of stability - which is what we have seen in the US. The proof is always in the pudding. I don't think it is confusing at all. Hedging the cost of oil as in your example is a financial risk. It is an attempt to mitigate the risk of rising oil prices. And there is nothing wrong with this kind of hedging. True, but as you point out that could be changing. Agreed. Specifically, Glass-Stegal was repealed by congress and regulation was further weakened by the Commodities Futures Modernization Act of 2000 and exempted derivative trading from state gambling laws. This deregulation was not inconsequential. It was major and it was a major mistake. What makes you think your average Joe or Jane has the knowledge or time to personally review their banks financials and risk disclosures to mitigate their risk? What makes you think a bank with excessive risk is going to readily make that disclosure? Yes FDIC insurance and all of the other bank regulations has made significant improvements in the nation's banking system.
Seems to me there is a lot of nit-picking so far in this thread. To me, the lesson is that when you have a market crash, the government has to spend big and flood the system with money and credit in order to avoid deflation and a real economic debacle. We did that in 2009 and then followed with a stimilus that kept us going but was not big enough to drive a faster pace of recovery (the Tea Party Republic opposition deserves credit for that). With our big mortgage foreclosure mess, it would be suicidal to seriously reduce the deficit. It would unravel all that we have accomplished, prices, stocks, business, and Federal tax receipts would all fall. With less government income, this folly would actually increase the federal debt and deficit. The EURO is holding up for the time being not because Greek debt is or is going to be reduced but because the FED and the European Central Bank are buying S. European government bonds to save the Global Economy from another major crisis. They are flooding the world economy with new money. Brough, civilization-overview dot com
Note that supply-side economics/Reaganomics is not, actually, "laissez-faire economics." It is corporate welfare and hand-outs to the rich. The "free market" rhetoric is just that - a convenient fig-leaf for union-busting and deregulation drives, quickly discarded when government favoritism is to be solicited.
It should be noted here that the OTC derivatives were mainly credit default swaps. This isn't like selling eggs. This is basically insurance. If one sells insurance, one must have the funds to back claims. That banks and investment companies didn't have the money to back claims was the core of the crisis. Yes, notional values are not the actual liability. That is explained in the link that I provided.
At the risk of posting while drunk... It's not likely that the majority were CDSs. The majority of OTC derivatives are (by a long way) interest rate derivatives (be they swaps, collars, swaptions, caps, etc...all of which just describe how you slice up your interest rate risk). Measured by notional amount they are at least 60% of the market, and in terms of raw numbers of contracts signed, they dwarf most anything else (because CDSs aren't dome on small deals, but interest rate derivatives can be used in a deal of any size). Even the credit default swap though isn't some nefarious instrument. The problem isn't that the sellers didn't have the money, full stop. Plenty of people enter into plenty of contracts and default because they don't have the money needed to pay them. The real problem was the systemic risk posed by the collapse of the real estate bubble...it's not even that AIG didn't have "a lot" of money, it's that they failed to imagine needing to pay out on so many contracts simultaneously. Imagine a bank. All banks have cash on hand. If you go to the bank and withdraw funds, no problem...but is half of all depositors turned up on the same day to withdraw all their money, almost no bank will have nearly enough cash on hand. It was certainly a failure of imagination on many people's parts that they didn't anticipate that sort of risk...but it's not as simple as a "lack of money" it's "not enough money to deal with a crisis that was an order of magnitude worse than had ever before been seen in the history of credit default swaps." Having reserves to pay losses is certainly prudent, but even then there are limits to how much you can reserve. You wouldn't keep cash on hand needed to pay 100% of the contracts in the worst case scenario, because that would be overkill (at least based on past experience it *seems* like it would be overkill). Your typical insurer doesn't even always have "adequate" reserves on hand to handle all practical risks, and they know it. Most rely on the reinsurance market to avoid holding truly massive reserves; in essence they sell insurance, and then they turn around and buy (re)insurance to cover them in case they underestimated the risk and don't have the funds on hand to pay the claims. And CDS sellers by and large did the same thing...to hedge their exposures they bought CDSs from others in the same way that an insurer sells insurance to us, and buys insurance from a reinsurer. With CDSs, though, that lack of transparency concealed the fact that a lot of unhedged risk was being held by companies that couldn't cope with severe downturns. They were, in effect, speculating that there would not be a downturn, and there was money to be made by them had they been right. When the downturn happened though, they new that "limited liability" would save them personally (even if their company was sunk). The problem for the CDS markets was that only the last two parties in a chain of contracts could see how risky the position of that very last guy in the chain was. Though, that said, not every CDS defaulted, so it's not as if there was some shady operator at the end of every deal. Also, those "shady" operators usually looked fine on paper, and absent a massive bubble bursting in the real estate market, they would have been, so even greater transparency might not have changed practices, since most market participants were overly optimistic about the likelihood and potential magnitude of the fall in the value of real estate. No one I'd read about was what people would have called "undercapitalized" at the time, because few people in the mainstream of the capital markets were anticipating the financial equivalent of an asteroid strike. Edit: Is there anything wikipedia doesn't know (or think it knows)? http://en.wikipedia.org/wiki/Derivative_(finance)#OTC_and_exchange-traded According to this foreign exchange contracts also beat out CDSs at least by notional amount, which could be right in my experience, but I wouldn't have guessed that. "Over the Counter" by the way is just pointless jargon for "private contract."
