Another forwarded post...

I apologize. Recently, this site has seen a lot of reposting of others rather than original diatribes. I am working on a couple ideas, but they take time. Instead I'll continue reposts as long as they fit under the general rubric of "Boring Political Diatribes."

This one comes from Robert Reich's Blog. Reich was my professor for one day and he is one of few economists who actually knows what he's talking about. You may notice that he was inspired by my other blog, but I can't really blame him for copying me, considering my immense popularity. Without further delay--Bailing Out the Speculators:

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Bailing Out the Speculators

Last night the Federal Reserve Board, acting as America’s central bank, sliced half a percentage point off the discount rate it charges banks for loans. The move was designed to give banks, in turn, more money to lend to their customers. But its primary purpose was to lift the confidence of investors and consumers in the United States and around the world that America’s central bank would do whatever necessary to keep the American economy going.

Ordinarily, central banks shouldn’t bail out speculators. It’s not their job to protect investors from themselves. In particular, it’s bad policy to make money cheaper – and investments thereby less risky – after investors have been hoisted on the petards of their own foolishness. That only invites more foolishness next time around.

Yet there’s precedent: In August of 1998, despite growing evidence of inflation, the Federal Reserve Board lowered interest rates in order to forestall a global credit crisis after Russia defaulted on its loans (many of which had been underwritten, foolishly, by several large Wall Street investment banks that assumed Russia would never default). Weeks later the Fed pressured banks to reschedule the debts of a giant hedge fund called Long-Term Capital Management, for fear that if the hedge fund went belly up, it would cause a crisis in credit markets.

In other words, ordinary rules don’t apply in extraordinary circumstances. That several thousand lower-income Americans inability to meet their mortgage payments set off a chain reaction leading to a worldwide credit crunch is an another such extraordinary circumstance. This one may require even more intervention by the Fed and other central banks around the world than we’ve witnessed already, in order to avoid a global financial meltdown. How much more? We’ll know more this coming week.

But what exactly happened to set this off? The story isn’t simple, but I’ll try to state it as simply as I can. In recent years, with so much money sloshing around the global economy, American banks and other mortgage lenders found themselves with lots of cash. They thought they could make a tidy profit by pushing home loans – not only on average Americans (whose eagerness to own a home or two thereby bid up housing prices) but also on poorer Americans who wanted to own a house but normally couldn’t afford the interest on the loans. Oddly, private credit-rating agencies judged these “sub-prime” loans to be relatively good risks. The loans were then sliced up and sold to other financial institutions where they were repackaged with other loans. Meanwhile, hedge funds created what can only be described as giant betting pools – huge amalgamations of money from pension funds, university endowments, rich individuals, and corporations – whose assumptions about risk were derived from the assumed low risks of the home loans (hence, the term, “derivatives”). Investors in these hedge funds had little or no understanding of what they were actually buying because hedge funds don’t have to disclose much of anything.

It was not just a housing bubble but a financial house of cards that would tumble when central bankers tightened up on the global money supply in order to fight inflation, as they inevitably would, and when the home loans were thereby revealed to be far riskier than thought. Because the bad loans are so widely dispersed and because so much additional credit is connected to them through derivatives, a contagion of fear has spread through financial markets. The credibility of the whole financial system has become shaky. Large numbers of stocks and bonds appear riskier than before, which is why Wall Street is taking a beating.

Americans are understandably nervous. Most American households have invested their savings in stocks and bonds. Most have also relied on the rising values of their homes as “nest-eggs” when they retire. The fact that the housing bubble has burst while stocks and bonds have lost ground is likely to cause American consumers to tighten their belts and cut their spending. Given that consumers comprise 70 percent of the economy, this could push America economy into a recession.

Europe and Asia are feeling the effects. The global financial market is now one big pool of money with spigots and drains all over the world. A loss of confidence on Wall Street is felt almost instantly in other financial capitals. Moreover, American consumers are the “energizer bunnies” of the global economy. Their purchases have maintained global demand even when other economies have sagged. The possibility that they won’t or can’t continue to buy is rocking all global corporations that sell them goods or services.

In other words, the Fed has to bail out the speculators because we’ll all suffer if it doesn’t.

That doesn’t mean, though, that the irresponsibilities now so clearly revealed in American financial markets should be excused or forgotten when the crisis ends. Wall Street has been living in an anything-goes world for too long. It has been widely – and wrongly – assumed that investors, creditors, and borrowers are smart enough to take care of themselves, especially if they’re big. That’s wrong.

The system has become so fast and so loose that many of the fancy financial instruments now in use, and the mathematical models on which they’re based, are too complicated for anyone except a computer to understand. Fortunes have been made exploiting tiny opportunities for arbitrage or devising new derivatives on the basis of data and risk assessments far less certain than they’re assumed to be.

Hedge funds have been operating huge financial casinos without having to disclose what they’re betting on, or why. Credit-rating agencies have cut corners or averted their eyes, unwilling to require the proof they need. They’ve been too eager to make money off underwriting of the new loans and other financial gimmicks on which they’re passing judgment. Banks and other mortgage lenders have been allowed to strong-arm people into taking on financial obligations they have no business taking on.

In order for the financial market to work well – to ensure fair dealing and to prevent speculative excess – government must oversee it. This mess occurred because no one was watching. The Fed and other central banks now have to clean it up. But regulators in American, Europe, and Asia have to make sure it stays clean. Hedge funds have to be more transparent. Credit-rating agencies must not have any relationship with underwriters. Banks and other mortgage lenders should be better supervised. Finance is too important to be left to the speculators.
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