Although, as a conservative, I’m inclined to believe that much of the current economic crisis is the result of Democratic politicians forcing banks to provide loans to those who would not be able to pay them back, I’m not so ideological as to believe that the Republicans had no role. This was clearly a bipartisan effort, and while notions of social justice were surely a factor, the Republicans controlled Congress for much of the Bush Administration and should have pushed harder to stem the tide that these bad policies had unleashed upon the market. Today, my brother offers his thoughts on how a lack of regulation contributed to the current economic crisis:

 

The best way I can answer this is by pointing you to this video:

 

http://www.cbsnews.com/stories/2008/10/05/60minutes/main4502454.shtml

 

It provides a great overview of the mess we are in, and perhaps the best part is in its layman terms description of why the deregulated CDS market has been so pivotal in creating this disaster.

 

Me, personally, I am usually inclined to support deregulation and making markets as free and hands-off as possible. I like to believe that the forces of supply and demand can do an infinitely better job of controlling the flow of goods and services in the best interest of the most people. For the most part, supply and demand does this better than government ever could. Even though it is not under the umbrella of regulation, you can see this in capitalist economies by looking no further than the number of companies/industries that have been privatized over the years and have performed far more efficiently after the switch. The market participants know business better than government ever could. And yet, this is exactly why deregulation may be needed.

 

A lack of regulation has created enormous problems for the economy. Again, I will defer to the 60 Minutes piece, as it basically says everything I was planning on discussing. At the end of the day–and I realize this argument may sound simplistic–I genuinely believe that people are simply too damn smart, and the broader investing public too damn ignorant. If you leave these financial professionals and engineers to themselves, they are going to create admittedly brilliant financial products, but ones that are potentially destructive. Collateralized debt obligations (CDOs) are an excellent example of this. If you read up on how these products are created, and how they allocate risk, the ingenuity is amazing. These types of securities, if backed by higher-quality assets, would be touted as revolutionary (in fact, they pretty much were considered such until recently). The problem, in this case, is that they combined this great innovation with a crappy product, and out of shortsightedness and greed, sold it to an unsuspecting body of consumers across the entire spectrum from large companies to individuals. The public, in turn, simply believed they were getting a great return on a safe product (frequently rated AAA by the rating agencies), made possible by the wonders of financial innovation.

 

I just don’t think it is realistic to expect the purchasers of such products to truly understand these types of products. The degree of sophistication is extremely high, and even relatively intelligent people like you and I would have trouble understanding the true degree of risk they possessed. I know we buy products (microwaves, cars, etc.) that we don’t truly understand all the time, but this is clearly different–in this day and age, where nearly everyone’s life savings are in the form of investments, you simply cannot allow such a massively popular yet massively complicated investment product to go unmonitored.

 

At each step of the way along this crisis, it is obvious that some form of regulation could have helped. Even the slightest degree of scrutiny over the banks’ mortgage lending practices would have made it apparent that the loans were doomed from the beginning. It is borderline criminal that ratings agencies, who are supposed to utilize all sorts of complex financial models and methods to assess the riskiness of investments, willingly slapped on AAA ratings to the mortgage-backed securities. You have a huge CDS market wherein people are told that they can hedge any perceived riskiness in these products through an insurance product, and meanwhile the insurers don’t even have the capital necessary to pay out in the case of a massive default scenario. To allow all of this to go on unfettered, when it is going on on such a massive scale, involving the life savings of individuals incapable of properly assessing risk, just doesn’t sit well with me.

 

This current crisis is just one example. There are countless numbers of ways through which anyone with enough money can manipulate the financial markets to their own benefit. In my opinion, laissez-faire capitalism simply cannot be applied successfully to financial markets, especially one dominated by the presence of a handful of gigantic participants as in the case of the US (courtesy, in part, to Glass Steagall).

 

Unfortunately, the biggest problem with regulation is that it ultimately comes down to how well the government executes it, and that is usually quite poorly. It is all too easy for these regulatory bodies to either waste massive amounts of taxpayer dollars or to simply end up aligning themselves with the very companies they are designed to regulate. However, financial professionals are simply too clever and too greedy to be left entirely unwatched, and they wreak their havoc with borrowed money. I realize that even with strict regulation in place, they will inevitably find loopholes and ways to still make a quick profit at other people’s expense. Still, that’s no justification to just sit idly by. Regulation has to be a continual process, constantly evolving to new innovations in the financial realm. How such regulation can be structured in such a way that it is effective in protecting people’s interests without overly inhibiting business, is admittedly beyond the scope of my knowledge.

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