Do Modern Finance And Government Intervention Crash The Financial System - Research Paper Example

? Financial Engineering Do modern finance and government intervention crash the financial system? Financial Engineering Do modern finance and government intervention crash the financial system? Introduction A series of bank failures and corporate scandals in United States over the last decade not only affected the US economy but also crashed the global financial system as a whole. The 2008 financial crisis is considered the worst financial crisis after the Great Depression in 1930s. This crisis resulted in severe issues including threat of total failure of large financial institutions, evictions, foreclosures, stock market downturns, housing market meltdowns, job terminations, and prolonged unemployment. Evidently, the 2008 global financial crisis significantly reduced the growth rate of countries worldwide and many western economies including US suffered huge net losses. A large number of business organizations went out of the business and thus many investors lost their money. Investigation reports indicate that it was the US housing bubble that led to the damage of financial institutions worldwide. Even though the US Federal government has pumped a huge volume of money into the market, the US economy has not yet completely recovered from the impacts of the crisis. This research paper will critically analyze the crash of the global financial system by referring to the book ‘Alchemists of loss: How modern finance and government intervention crashed the financial system’ written by Dowd and Hutchinson. The paper will particularly evaluate whether the elements of modern finance and government intervention have played a role in crashing the financial system. An Overview of Modern Finance Emergence of floating currencies was a major event led to the development of modern finance. In 1971, Richard Nixon, the 37th president of the United States, suspended the dollar’s convertibility into gold in order to resolve financial difficulties associated with a huge trade deficit and Vietnam War. This policy brought an end to the Bretton Woods system of fixed exchange rates whereby capital flow from one country to another had been limited by exchange regulations. Since investing abroad was an expensive task under the Bretton Woods system, pension funds had kept their money home. According to Caldentey and Vernengo (2010), the policy amendment made the currencies floatable and entirely changed the way financial markets operate; and this change also created the need of currency hedging and resulted in the introduction of futures in financial markets. The floating exchange rates played a crucial role in the development of liberalized markets, which eliminated credit controls and promoted the entry of new lenders. Another effect of the new exchange rate system was the abolition of capital controls and this process led to a sharp appreciation of the dollar and pound. Institutions like insurance companies and pensions funds could freely move money without cross border limitations. In 1975, America introduced a financial reform to eliminate the distinction between brokers and jobbers and thereby to slash commissions. This reform gradually led a long term decline of broking revenues and widely restructured the industry. The increased need for capital forced investment banks either to make money on the stock market or to combine with commercial banks. The broadening of banking businesses resulted in more complex banking transactions and firms started to engage in more risky business ventures. In order to mitigate the growing level of business uncertainty, new forms of exchange rate risk reduction mechanisms such as options and swaps were introduced. In the words of Ryder, “futures, options, and swaps all have the same characteristic: a small position can lead to a much larger exposure” (cited in The Economist). In order to take advantages of the changes in global business environment resulting from globalization, creditors began to lend huge amounts of money to entrepreneurs and other growing business ventures. Banks and other credit lending institutions focused only on the volume of business transactions and net profitability, but not on clients’ creditworthiness. Evidently, this unsecure credit lending often ended up in the bankruptcy of corporate giants and collapse of many major banks. The principle of deregulation is the core concept of the modern finance. Even though the failures of Drexel Burnham and Baring Brothers questioned the principle of deregulation, regulators considered these problems as individual events of fraud or mismanagement and hence they tried to resolve the issue by redesigning their regulatory structures. Many economists hold the view that different issues of modern finance played a significant role in increasing the mismatch between banks’ assets and liabilities. In addition, the housing industry experienced higher prices and the situation made loans even less affordable to the poor. Under the concept of modern finance, each financial innovation appeared to be the object of speculation and this trend was fuelled by cheap money. According to Ryder, another major characteristic of modern finance is that “bankers and traders were always one step ahead of the regulators” (as cited in The Economist). Regulators strongly believed that deregulation and financial liberalization would promote economic growth. How does the modern finance relate to the recent financial crisis? As discussed earlier, the floating exchange rates limited the level capital controls. Eventually, this situation worsened issues associated with hot money flows in many parts of the globe. In addition, the sharp appreciations of the dollar and pound posed many issues to US’ and UK’s exporters and this condition exacerbated the recession of the early 1980s. Evidences suggest that since insurance companies and pension funds could move money across borders, this situation raised potential challenges to Britain’s stockbrokers and marketmakers who had managed share trading. An anti-competitive environment of fixed commissions allowed brokers to charge too much and this situation hurt the interests of big investors. Unsecure credit lending was one of the major reasons contributed to the recent global financial recession and collapse of the financial system. In order to fasten the business expansion, banks and other financiers extended credit to people and businesses beyond a secure limit. They did not even make certain that whether the client would repay the loan/credit within the stipulated period. Naturally, this thoughtless and greedy business practice led to defaults in loan repayments and hence weakened banks’ financial stability. In addition, unregulated derivatives market and shadow banking raised significant challenges to the US economy. A series of bank failures in US over the period 2008-09 can be mainly attributed to liberalized and unsecure credit lending practices. At the same time, liberalized money lending policies put many American corporate giants in huge troubles, including bankruptcy. Since US banks offered extensive credit facilities without much restriction, organizations were keen to exploit the favorable business environment and hence they borrowed beyond their debt limits. Evidently, huge debt obligations adversely affected the operational efficiency of many business houses and ultimately impeded their business growth. Hence, the unsecure credit lending policies dreadfully impacted both banking institutions and business organizations. In their book, Dowd and Hutchinson (2010) also opine that poor banking policies made United States highly vulnerable to the recent financial crisis (pp.58-59). From the view point of the authors; mainly five factors including rampant speculation, thoughtless government intervention, poor regulation/legislation, misguided monetary policies, and misunderstanding of the new financial technologies are the major factors contributed to the recent crisis (pp.58-59). While analyzing the current global economic environment, it seems that all these five factors are the direct or indirect results of the modern finance. The modern finance paved the way for innovations in the financial market and which in turn increased the rate of speculative trade transactions. It is obvious that speculative trade involves greater level of risk and hence such transactions are more likely to cause huge losses to parties involved. In other words, speculative trade is not a potential business practice that would long term sustainability of the business. Mortgage companies also played their part to exacerbate the 2008-09 global financial crisis. In the US, mortgage companies offered extensive credit facilities to home buyers regardless of their income or credit rating. Throughout the mid 2000s, those companies greatly promoted home loans through radio ads and other promotion techniques and significantly lowered lending standards with intent to allow huge mortgages to even people with no assets, no income, and no credit rating. Mortgage writers did not pay particular attention to the information on mortgage applications and they even encouraged applicants to obtain the benefit of home mortgages by submitting false information. Evidently, this practice increased the level of home mortgages in the United States. Americans had held the strong belief that home prices would never decline and continue to grow. Based on this speculation, people kept on the practice of buying numerous homes in order to make profit by selling homes for a higher future price or renting them (Moffat, 201). However, the situation was changed by the fall of 2008 when the house prices continued to decline. A large number of people with more than one house were put into huge financial troubles and consequently they defaulted on their mortgage repayments. As a result, banks experienced potential capital and liquidity problems as value of their mortgage backed CDOs dramatically declined following the fall of home prices. Banks really struggled to meet their working capital requirements as depositors were increasingly withdrawing money; they also strived to find buyers or to seek merger options before they filed for bankruptcy. To illustrate, the Bear Stearns’s share price (as cited in Sidel, Berman, and Kelly, 2008) was $171 in January 2007 and it was dropped to $2 per share when the bank was sold to JP Morgan in March 2008. The defaults in mortgage repayment resulted in great financial issues in the country. Reports indicate that rating companies’ unethical practices noticeably contributed to the recent recession. Rating companies like Moody’s, Standard and Poor’s, and Fitch rated collateralized debt obligations (CDOs) as investment grade securities without proper evaluation as these companies were paid by banks and other financial institutions. Since byelaws require pension funds, cities, and states to invest in investment grade securities, many of those highly rated CDOs could take unfair advantages of such investments. It is evident that poor banking regulations added to the recent financial crisis. If the authorities concerned had properly regulated banking policies, banks and other financiers would not have offered unsecure home mortgages to people. Furthermore, frequent development of financial technologies created great confusions in banking transactions and this issue is also one of the direct consequences of the modern finance. Government intervention in the financial system While analyzing the US economy, it seems that the Federal government has notably intervened in the financial system over the last century. Dowd and Hutchinson (2010) narrate many examples in their book. The authors point out that the introduction of Federal deposit insurance was a wrong move unlike most of the people had believed. They assert that the introduction of deposit insurance benefited bankers to gain their depositors’ confidence for granted and which in turn assisted them to increase their lending risks as well as leverage ratios (pp.270-271). Since such practices were more likely to increase the revenues, the depositors were not much concerned about the banks’ excess risk taking attitude. As a result, deposit insurance led to excess risk taking practices and which in turn increased the level of business uncertainty. Dowd and Hutchinson (2010) say that this Federal government intervention assisted even most insolvent banks practicing most unsound investment policies to remain in the market indefinitely by merely increasing deposit interest rates. According to the scholars this is what happened to US banks over the period 1930s to 1980s (p.272). Similarly, many other federal government interventions can be identified throughout the last century. Dowd and Hutchinson also reflects that establishment of regulatory systems (US Securities and Exchange Commission) by the Federal government to assure investor protection was another government level intervention resulted in damage of the global financial system (p.274). Authors like Burke strongly support the findings of Dowd and Hutchinson. Referring to the causes and impacts of the recent global recession, Burke (2009) opines that the principle of investor protection does not benefit the global financial system. Before the introduction of Federal investor protection, investment firms had to provide investors with credible reassurance in order to attract investments. The firms did so by maintaining good market stature and making their presence in the community. In that time, investors were completely responsible for their money. With the introduction of the investor protection policy, people considered the SEC license as a close substitute to market stature. Investment firms really enjoyed this newly formed business environment as they could claim that they were able to do risk-free business on the strength of the SEC license. The investor protection policy resulted in the deterioration of investment firms’ operational standards because the SEC had implicitly promised that those firms were fit to operate. In order to ensure greater transparency and accountability of transactions, the SEC introduced enormous reporting requirements. However, according to a 2002 Senate study, the SEC officials could scrutinize only 16% of the all annual company reports submitted in the previous accounting year. The officials had not assessed the annual reports of Enron in a decade. Undoubtedly, such issues significantly contributed to the 2008 global financial crisis. Finally, the Federal government paid billions of dollars in bailouts to safeguard corporations from bankruptcy in the event of the recent global recession. In order to support the acquisition of Bear Stearns by J.P Morgan Chase, the Federal government issued a nonrecourse loan of $29 billion to Bear Stearns arguing that the firm’s collapse would have impacted the real economy and impeded the growth of investments across the US markets (Minutes of the…). Impacts of government interventions on the US financial system In the view of Dowd and Hutchinson, the Federal government interventions to stabilize the US economy can have far reaching adverse impacts on the country’s financial system. The authors argue that the implemented government interventions are short term focused and hence those initiatives are likely to impede the growth of the US economy in the long run (pp.269-280). This view is supported by the a University of Illinois business expert, Agarwal (2009), who warns that massive bailouts and other policy initiatives executed by the US government to manage the economic slowdown could set the nation’s economy nearly fifty years back. She continues that the Federal government interventions are “stifling innovation, entrepreneurship, and other free market dynamics that fuel long term growth” (Agarwal, 2009). It is clear that frequent innovations and effective entrepreneurship are necessary to enhance the economic, industrial, and technological development of a region. However, many of the recent Federal government interventions do not support entrepreneurship or innovations and therefore such policies would ultimately challenge the dominance of the US economy. While closely evaluating the US government’s effort to stabilize its struggling economy, it seems that politicians are just trying to fix the issue of current crisis quickly. This effort to find a quick solution to the crisis would weaken the foundation of the economy. It is evident that excessive government bailouts stifle free market competition, which is one of the key components fuelling the economy growth of a country. Business experts like Agarwal claim that provision of huge governmental funds to propel the growth of large, existing firms would assist those firms to gain an unfair edge over its rivals and thereby to eliminate their potential rivals from the market. By offering huge bailouts, the government allows the economic power to be in the hands of inefficient firms that failed to accurately maintain the risk-return relationship in their business dealings. In simple words, the government offered bailouts have damaged the balance of the country’s business environment and are eventually crashing its financial system. The observations made by Dowd and Hutchinson are in close line with the views of the American economist Taylor (2008), who argues that the recession was caused as a result of excess monetary expansion and the Federal government’s unpredictable nature of responsive policies. Alan Greenspan, the former Chairman of the Federal Reserve of the United States, also opines that government interventions and inefficient Federal Reserve Bank policies have created many financial difficulties in the US. Federal government interventions during the last decade resulted in a shift of economic power from market forces to the hands of government. As Agarwal (2009) points out, the same economic environment once impeded economic development in India and Russia. It is uninteresting to see that today many of the US corporations survive not because of their entrepreneurial spirit or sound decision making capabilities but because of unfair government support and political power. Agarwal (2009) points out an important fact that “when businesses and consumers make economic decisions in a free market, any one being wrong is not a big deal. But if only the government is deciding, the consequences of not getting it right can be catastrophic to the economy” (Agarwal, 2009). When the government provides free money to banks, the government would obtain great control over the banks and hence it may influence the banks’ decisions such as to whom and how loans must be given. Undoubtedly, such a regulative business environment would hurt the banks’ operational efficiency and ability to be flexible. Many economists strongly argue that government interventions in the financial system caused an increase in unemployment rate. To illustrate, when the Federal government allows excess bailouts to huge and existing corporations, growing firms and entrepreneurs struggle to confront with those corporations in the context of financial crisis. Naturally, this type of government intervention eliminates many small business concerns from the market and discourages the development of entrepreneurs. Under such circumstances, existing employees may be terminated and many other fresh candidates may not be hired. This situation would worsen the economic growth of the country which in turn may affect the efficiency of the country’s financial system. Similarly, economic freedom is necessary to build an effective financial system and thereby to fasten the economic growth of a country. To illustrate, statistical data (as cited in Miller (2009) indicate that countries rated as most free as per the 2009 Index of Economic Freedom had generated more than $40,000 in average per capita incomes. This rate is nearly 10 times more than the income levels in nations where economic freedom is limited. According to Miller (2009), ‘individual empowerment, non-discrimination, and the dispersion of power’ are the central principles of economic freedom. The writer strongly says that the most of the intervention programs introduced by the US government hurt the concept of economic freedom. For instance, by providing huge bailouts to struggling corporations, the government directly acted against the principles of non-discrimination and the dispersion of power and indirectly against the principle of individual empowerment. Miller argues that the bailout programs executed by the US government did not increase the economy’s stability but resulted in greater level of uncertainty and volatility. Furthermore, a financial market requires stable government policies to properly price assets and to ensure smooth flow of transactions. Therefore, government interference characterized with frequent policy changes would never benefit a financial system. How to rebuild the financial system? In order to rebuild the global financial system, governments have to limit their financial market interventions. Firstly, regulators must reassess the provisions of the investor protection as this policy allows investment firms to remain in the market on the strength of SEC license even if their performance is very weak. It is recommendable for the SEC to ensure that investment firms strictly keep specified operational standards. Such a practice would limit the financial liabilities of the SEC to a great extent and secure the money of investors. It is also better to enlighten investors about the necessity of investing with financially sound firms. In addition, it is advisable for governments, particularly the federal government, to ensure economic freedom in the market as this condition is essential to build a strong and sustainable financial system. As part of this policy, the government should not provide any corporation with unfair advantages (bailout money). In contrast, it is better to let those corporations to freely compete in the market and survive based on their performance. It is advisable for the government to foster entrepreneurship and innovations in the country as it is the best way to build a sustainable economic environment in the country. For this purpose, the government has to lend financial grants and subsidies to innovative entrepreneurs. In addition, development of a strong small scale industry is a better strategy to rebuild the financial system because those firms are less vulnerable to scandals. Evidences suggest that emerging economies like India and China could successfully survive the global financial crisis 2008-09. Economies claim that stringent banking policies and regulations assisted these economies to overcome the recession without much damage. The United States must also give specific focus to its banking policies because a series of bank failures over the last decade made the country prone to the financial crisis. It is specifically recommendable for regulators to thwart unsecure credit lending practices. Under any circumstance, banks should not lend money to any person unless he/she submits adequate securities. As discussed earlier, issue of insecure housing mortgages played a notable role in putting the US economy in great financial troubles. Hence, the government has to prioritize the long term sustainability of its economy while trying to raise living standards of its citizens. Similarly, the US regulators must review its modern finance policies as many of those policies influence business firms to take high level of risks. Even though exchange rate tools like futures and options were developed to minimize the risk of currency loss, these techniques are being widely used for speculative business activities. Evidently, speculative trade is more likely to cause loss and thereby to crash the financial system; therefore regulators should be vigilant to control speculative trade practices. In order to enhance the fast recovery of the US economy, corporations have to thoughtfully set their safe debt levels beyond which debt should not be taken for business expansion or other purposes. Finally, rating companies must be professional and ethical in ranking banks and other business corporations. Conclusion In total, the claims of Dowd and Hutchinson are supported by many theoretical concepts, empirical evidences, and expert opinions. It is observed that floating exchange rates limited the level of capital controls and this situation raised many strategic challenges to economies like US and UK. Financial market tools like options and futures increased the level of speculation in trade activities. Unsecure credit lending is a direct effect of modern finance and this issue not only challenged the feasibility of banks but also led to the collapse of corporations that borrowed excess funds. In addition, governmental interventions like deposit insurance and investor protection significantly contributed to the 2008 global financial crisis. Finally, the excess bailouts offered by the Federal government in the event of the recent recession worsened the status of the financial system. Hence, governments across the globe must identify and eliminate negative impacts of the modern finance and avoid excess government level interventions in the financial system. References Burke, J. (2009). Re-examining investor protection in Europe and the US. Electronic Journal of Law, 16 (2). Caldentey, E. P & Vernengo, M. (2010). Modern finance, methodology and the global crisis. Real world Economics Review. (52): 69-81. Retrieved from http://www.paecon.net/PAEReview/issue52/CaldenteyVernengo52.pdf Dowd, K & Hutchinson, M. (2010). Alchemists of loss: How modern finance and government intervention crashed the financial system. US: John Willey & Sons. The Economist. (2008). A short history of modern finance. Retrieved from http://www.economist.com/node/12415730 Moffat, M. (2012). Why have home prices soared? It’s fundamental. The globe and mail. Retrieved from http://www.theglobeandmail.com/report-on-business/economy/economy-lab/why-have-home-prices-soared-its-fundamental/article4437090/ Miller, A. T. (2009). Government Intervention: A Threat to Economic Recovery. The Heritage Foundation. Retrieved from http://www.heritage.org/research/testimony/government-intervention-a-threat-to-economic-recovery Minutes of the board of governors of the Federal Reserve System. (2008). Retrieved from http://www.federalreserve.gov/newsevents/press/other/other20080627a2.pdf Sidel, R., Berman, DD. K & Kelly, K. (2008). J.P. Morgan Buys Bear in Fire Sale, As Fed Widens Credit to Avert Crisis. The Wall Street Journal, July 17. Retrieved from http://online.wsj.com/article/SB120569598608739825.html Taylor, J. B. (2008). The financial crisis and the policy responses: An empirical analysis of what went wrong. Retrieved from http://www.stanford.edu/~johntayl/FCPR.pdf Read More