03-23-2008, 04:07 PM
GREED HURTS:
CAUSES OF THE GLOBAL FINANCIAL CRISIS
Oskari Juurikkala
“Greed is good,” insisted Gordon Gekko in the 1987 film Wall Street. Most of us disagree. Recent events in the mortgage lending industry prove us right.
The “subprime loan crisis” has been making headlines since it began in August. It refers to the fact that a relatively high percentage of mortgages offered to people with significant probability of default have gone sour.
The moniker is a bit misleading, though. The crisis we are witnessing starts from risky loan deals but will extend to all varieties of credit and risk: consumer loans, credit cards, businesses, and so on. It is just about to heat up but the roots of this crisis were laid years ago.
It’s a credit crisis, but credit per se is not the problem. The problem lies in how credit was traded from one hand to another on an unprecedented scale. This was done through financial innovations called derivatives.
Derivatives are contracts that allow companies to trade risks that derive from some other underlying assets. For example, a currency futures contract lets you to lock into a specific foreign exchange rate. It’s a sensible move if you trade abroad and do not wish to carry the risk of a sudden change in exchange rates.
Recent decades brought much trickier – and riskier – derivatives, such as “over-the-counter credit default swaps (CDS).” Sound complex? It is.
Credit derivatives permit lenders to transfer their credit risks (mortgage defaults) to third parties, such as hedge funds. Thus banks can do more business. In the 1990s and 2000s, credit derivatives became a massive global gamble.
If used properly, derivatives are useful and ethically unobjectionable. They enable efficient risk allocation that benefits all parties concerned. But their abuse is a nightmare. They become a house of cards, built on greed.
Derivatives could, for instance, be used to circumvent regulations that protect investors and the public. These stakeholders lack the time or ability to track the risks taken by companies, which is why financial institutions cannot freely invest in risky asset classes. But through derivatives, many institutions made complex speculative bets without regulators catching on.
If it works, it pays off. Companies make abnormal profits and managers take huge bonuses. If it doesn’t work, someone else will usually pay the bill, such as investors and bank depositors.
Then there’s the Fed, always keen to save bankers by printing more money. The losers are the unsuspecting working and middle classes, whose savings are eroded by inflation. What to do?
One thing we need is better rules. True, we have lots of regulations in financial markets. Some are so complex that most professionals can’t follow them. Often they are equally unhelpful.
Derivatives are a case in point. After Enron, we got the Sarbanes-Oxley Act, which costs fortunes to U.S.-listed companies. Despite this new layer of regulation, abuses are rampant: massive off-balance sheet items, shadowy over-the-counter deals, unrealistic marking-to-model pricing, murky offshore special purpose entities (SPEs). Risk-hiding has become widespread, often with the explicit or tacit approval of regulators.
We need simpler rules, ones that tackle the real issues. But more than rules, we need personal conversion.
Remember Enron? “They broke the law,” people say. Well, yes. They also abused financial derivatives, SPEs and a range of other tricks to hide their excessive risks. But what really destroyed Enron, and made it so dangerous, was its corporate culture. It was infected with institutionalized greed.
The current situation is Enron writ large. We have more derivatives, more leverage, and bigger losses. Wall Street is hardly superior when it comes to generosity and detachment from worldly goods.
The Apostle Paul identified the issue 2,000 years ago: the love of money is the root of all evils (1 Timothy 6: 10). He concurred with Jesus, who said, You cannot serve God and mammon (Matthew 6: 24).
The goods of this world are good. But we have to pursue them in the right order, guided by love of God and neighbor. It applies to personal life and it applies to finance. Wisdom shuns greed. Prudence depends on the moral virtues, as Aristotle taught. Greed is like pride: it blinds.
2008 will be a tough year. We may witness the largest financial crisis in history. We need to study the past to see how we got here. But more than that, we must think about the future.
In order to make finance safe for our children, we need better laws and regulations. This is hard to accomplish, however, and it’s never enough. Unless people – at least most people – are willing to do what is right because it is right, our laws will be objects of mockery and abuse.
First we need a change of heart. Perhaps we’ll then get the laws right too.
PRINTING MONEY FOR WALL STREET
Oskari Juurikkala
http://www.acton.org/commentary/440_prin...street.php
The global financial system is in a deepening crisis, largely due to greedy gambles with complex financial derivatives. The bailout of Bear Stearns Cos., in which the Fed provided $30 billion loan to J.P. Morgan Chase to acquire the investment bank, is only the latest -- and probably not the last -- rescue mission from the central bank. Overall, the response of the Bernanke-led Federal Reserve to the global financial meltdown has been exceedingly simple: lower interest rates.
It is debatable whether that is an effective solution to the problem. It risks destroying the international demand for dollars, and a declining exchange rate would imply rapid price inflation at home as well as increasing pressure on foreign investors to take their money out. Both effects would exacerbate the crisis.
But that is a technical issue. The Fed strategy raises more fundamental issues.
When a central bank lowers interest rates, it engages in an activity that is loaded with moral meaning. The jargon of the macroeconomist can be misleading. Lower interest rates are achieved by increasing the money supply, which is basically equivalent to “printing money out of thin air,” and selling it cheaply to the banking community (although technically it is now achieved by creating fictitious accounting entries).
The moral dimension becomes plainer if we consider a private person doing that. It is called fraud. Counterfeit money enriches the fraudster at the expense of the rest of the society. Creating more paper slips does not bring about more economic resources (production or consumption goods), but only serves to redistribute them. The counterfeiter immediately acquires additional money at his disposal, whereas the purchasing power of the money balances of the rest is slowly eroded.
Modern central banking claims to serve lofty goals: high employment, price stability, and economic growth. In fact, it only enriches those who run the system. Sometimes it is the national government. Consider, for instance, Robert Mugabe’s Zimbabwe with its well-over 1,000 percent (and rising) inflation rate.
In other instances, the central bank is a private entity serving the interests of the financial elite. This was true of most central banks historically, including the Bank of England (founded in 1694), which was only nationalized in 1946.
Unbeknownst to many, the 1913-founded U.S. Federal Reserve System also comes under this category. It is a private corporation owned by its member banks, about whose owners little is known. As a special privilege, the Fed has never undergone a complete independent audit, and it is claimed that it keeps some of its records secret.
One may also challenge the lofty goals of central banks. Inflation is largely caused by increasing the money supply. In consequence, inflation encourages living on debt and discourages prudence and thrift.
Moreover, by creating artificially low interest rates, central banks foster damaging boom-bust cycles, as economists Ludwig von Mises and F.A. Hayek demonstrated. The dot.com bubble, which collapsed in 2000, and the real estate and overconsumption bubble, which is coming to an end today, are just the most recent examples.
So much for stability, economic growth, or high employment.
The Old Testament provides some principles on sound money. Complaining of the sins of Judah and Jerusalem, the prophet Isaiah denounced monetary debasement: “Your silver is turned to dross, your wine is mixed with water” (Isaiah 1:22). Likewise, the Lord exhorted the Jewish people: "Do not act dishonestly in using measures of length or weight or capacity. You shall have a true scale and true weights…” (Lev. 19:35-36)
Debasement and tampering with weights and measures have been a temptation throughout the history of money and banking. They are the essence of the more complex methods of monetary inflation practiced today.
Then there is fractional-reserve banking, the use of demand deposit money in lending business. Many economists, including Milton Friedman and others at the University of Chicago in earlier decades, have identified it as the source of banking instability throughout modern times. Fractional-reserve banking was censured already by Roman jurists, who found it dishonest and legally unsound. Yet modern scholarship shows that it was precisely this instability that provided the justification for inflationary central banking.
The Founders of the United States grasped this. In his letters, Thomas Jefferson wrote numerous lines on the problem with unsound money. In an 1817 letter to Josephus B. Stuart, he noted the consequences of paper money: "That paper money has some advantages is admitted. But that its abuses also are inevitable and, by breaking up the measure of value, makes a lottery of all private property, cannot be denied.”
Jefferson likewise understood the problem with unsound banking. In a letter to John Taylor he said: "I sincerely believe\... that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity under the name of funding is but swindling futurity on a large scale." (1816)
These courageous words ring remarkably relevant today. The roots of the current crisis lay in the manipulation of the money of American citizens. More of that will not solve the problem. Will we have the courage to go to the heart of the matter?
CAUSES OF THE GLOBAL FINANCIAL CRISIS
Oskari Juurikkala
“Greed is good,” insisted Gordon Gekko in the 1987 film Wall Street. Most of us disagree. Recent events in the mortgage lending industry prove us right.
The “subprime loan crisis” has been making headlines since it began in August. It refers to the fact that a relatively high percentage of mortgages offered to people with significant probability of default have gone sour.
The moniker is a bit misleading, though. The crisis we are witnessing starts from risky loan deals but will extend to all varieties of credit and risk: consumer loans, credit cards, businesses, and so on. It is just about to heat up but the roots of this crisis were laid years ago.
It’s a credit crisis, but credit per se is not the problem. The problem lies in how credit was traded from one hand to another on an unprecedented scale. This was done through financial innovations called derivatives.
Derivatives are contracts that allow companies to trade risks that derive from some other underlying assets. For example, a currency futures contract lets you to lock into a specific foreign exchange rate. It’s a sensible move if you trade abroad and do not wish to carry the risk of a sudden change in exchange rates.
Recent decades brought much trickier – and riskier – derivatives, such as “over-the-counter credit default swaps (CDS).” Sound complex? It is.
Credit derivatives permit lenders to transfer their credit risks (mortgage defaults) to third parties, such as hedge funds. Thus banks can do more business. In the 1990s and 2000s, credit derivatives became a massive global gamble.
If used properly, derivatives are useful and ethically unobjectionable. They enable efficient risk allocation that benefits all parties concerned. But their abuse is a nightmare. They become a house of cards, built on greed.
Derivatives could, for instance, be used to circumvent regulations that protect investors and the public. These stakeholders lack the time or ability to track the risks taken by companies, which is why financial institutions cannot freely invest in risky asset classes. But through derivatives, many institutions made complex speculative bets without regulators catching on.
If it works, it pays off. Companies make abnormal profits and managers take huge bonuses. If it doesn’t work, someone else will usually pay the bill, such as investors and bank depositors.
Then there’s the Fed, always keen to save bankers by printing more money. The losers are the unsuspecting working and middle classes, whose savings are eroded by inflation. What to do?
One thing we need is better rules. True, we have lots of regulations in financial markets. Some are so complex that most professionals can’t follow them. Often they are equally unhelpful.
Derivatives are a case in point. After Enron, we got the Sarbanes-Oxley Act, which costs fortunes to U.S.-listed companies. Despite this new layer of regulation, abuses are rampant: massive off-balance sheet items, shadowy over-the-counter deals, unrealistic marking-to-model pricing, murky offshore special purpose entities (SPEs). Risk-hiding has become widespread, often with the explicit or tacit approval of regulators.
We need simpler rules, ones that tackle the real issues. But more than rules, we need personal conversion.
Remember Enron? “They broke the law,” people say. Well, yes. They also abused financial derivatives, SPEs and a range of other tricks to hide their excessive risks. But what really destroyed Enron, and made it so dangerous, was its corporate culture. It was infected with institutionalized greed.
The current situation is Enron writ large. We have more derivatives, more leverage, and bigger losses. Wall Street is hardly superior when it comes to generosity and detachment from worldly goods.
The Apostle Paul identified the issue 2,000 years ago: the love of money is the root of all evils (1 Timothy 6: 10). He concurred with Jesus, who said, You cannot serve God and mammon (Matthew 6: 24).
The goods of this world are good. But we have to pursue them in the right order, guided by love of God and neighbor. It applies to personal life and it applies to finance. Wisdom shuns greed. Prudence depends on the moral virtues, as Aristotle taught. Greed is like pride: it blinds.
2008 will be a tough year. We may witness the largest financial crisis in history. We need to study the past to see how we got here. But more than that, we must think about the future.
In order to make finance safe for our children, we need better laws and regulations. This is hard to accomplish, however, and it’s never enough. Unless people – at least most people – are willing to do what is right because it is right, our laws will be objects of mockery and abuse.
First we need a change of heart. Perhaps we’ll then get the laws right too.
PRINTING MONEY FOR WALL STREET
Oskari Juurikkala
http://www.acton.org/commentary/440_prin...street.php
The global financial system is in a deepening crisis, largely due to greedy gambles with complex financial derivatives. The bailout of Bear Stearns Cos., in which the Fed provided $30 billion loan to J.P. Morgan Chase to acquire the investment bank, is only the latest -- and probably not the last -- rescue mission from the central bank. Overall, the response of the Bernanke-led Federal Reserve to the global financial meltdown has been exceedingly simple: lower interest rates.
It is debatable whether that is an effective solution to the problem. It risks destroying the international demand for dollars, and a declining exchange rate would imply rapid price inflation at home as well as increasing pressure on foreign investors to take their money out. Both effects would exacerbate the crisis.
But that is a technical issue. The Fed strategy raises more fundamental issues.
When a central bank lowers interest rates, it engages in an activity that is loaded with moral meaning. The jargon of the macroeconomist can be misleading. Lower interest rates are achieved by increasing the money supply, which is basically equivalent to “printing money out of thin air,” and selling it cheaply to the banking community (although technically it is now achieved by creating fictitious accounting entries).
The moral dimension becomes plainer if we consider a private person doing that. It is called fraud. Counterfeit money enriches the fraudster at the expense of the rest of the society. Creating more paper slips does not bring about more economic resources (production or consumption goods), but only serves to redistribute them. The counterfeiter immediately acquires additional money at his disposal, whereas the purchasing power of the money balances of the rest is slowly eroded.
Modern central banking claims to serve lofty goals: high employment, price stability, and economic growth. In fact, it only enriches those who run the system. Sometimes it is the national government. Consider, for instance, Robert Mugabe’s Zimbabwe with its well-over 1,000 percent (and rising) inflation rate.
In other instances, the central bank is a private entity serving the interests of the financial elite. This was true of most central banks historically, including the Bank of England (founded in 1694), which was only nationalized in 1946.
Unbeknownst to many, the 1913-founded U.S. Federal Reserve System also comes under this category. It is a private corporation owned by its member banks, about whose owners little is known. As a special privilege, the Fed has never undergone a complete independent audit, and it is claimed that it keeps some of its records secret.
One may also challenge the lofty goals of central banks. Inflation is largely caused by increasing the money supply. In consequence, inflation encourages living on debt and discourages prudence and thrift.
Moreover, by creating artificially low interest rates, central banks foster damaging boom-bust cycles, as economists Ludwig von Mises and F.A. Hayek demonstrated. The dot.com bubble, which collapsed in 2000, and the real estate and overconsumption bubble, which is coming to an end today, are just the most recent examples.
So much for stability, economic growth, or high employment.
The Old Testament provides some principles on sound money. Complaining of the sins of Judah and Jerusalem, the prophet Isaiah denounced monetary debasement: “Your silver is turned to dross, your wine is mixed with water” (Isaiah 1:22). Likewise, the Lord exhorted the Jewish people: "Do not act dishonestly in using measures of length or weight or capacity. You shall have a true scale and true weights…” (Lev. 19:35-36)
Debasement and tampering with weights and measures have been a temptation throughout the history of money and banking. They are the essence of the more complex methods of monetary inflation practiced today.
Then there is fractional-reserve banking, the use of demand deposit money in lending business. Many economists, including Milton Friedman and others at the University of Chicago in earlier decades, have identified it as the source of banking instability throughout modern times. Fractional-reserve banking was censured already by Roman jurists, who found it dishonest and legally unsound. Yet modern scholarship shows that it was precisely this instability that provided the justification for inflationary central banking.
The Founders of the United States grasped this. In his letters, Thomas Jefferson wrote numerous lines on the problem with unsound money. In an 1817 letter to Josephus B. Stuart, he noted the consequences of paper money: "That paper money has some advantages is admitted. But that its abuses also are inevitable and, by breaking up the measure of value, makes a lottery of all private property, cannot be denied.”
Jefferson likewise understood the problem with unsound banking. In a letter to John Taylor he said: "I sincerely believe\... that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity under the name of funding is but swindling futurity on a large scale." (1816)
These courageous words ring remarkably relevant today. The roots of the current crisis lay in the manipulation of the money of American citizens. More of that will not solve the problem. Will we have the courage to go to the heart of the matter?