The financial system isn’t (or part of) the economy, it wrecks the economy.
By Alex Mai at 4 July, 2009, 11:08 pm
Some of you may confuse the financial system with the economy. They are related but not the same thing. I’ve researched over the internet to find out how are they interact, especially the structure of the U.S financial system. U.S has the biggest economy in the world, that’s why people participate in finance earn the most money: the U.S financial system wrecks the economy because it is sucking the money out of the economy. However, the economy need to help it when it is in trouble. Hilarious, huh?
The financial system vs. the economy
“In the economy people buy and sell goods and service, including making capital improvements. The economy is necessary for day to day living.
In the financial system, people make side bets on the economy. It is basically a casino filled with gamblers.
The size of the economy is about $45 trillion / year for the world GDP.
The size of the financial system is above $200 trillion, principally in derivatives and similar unregulated contracts. Each day, upwards of $5 trillion in payments are made to settle trades (i.e. the daily “handle” in the casino).
We need to put bariers (sic) between the economy and the finacial system so that the gamblers in the financial system casino can’t wreck the economy.” — From Democratic Underground
How does financial system wrecks the economy?
So let’s look at the Financial Industry. It is composed of commercial banks, savings banks, insurance companies, commodities markets, stock markets, and the real estate markets. All of these entities are all connected and intertwined. Commercial banks make money by loaning money to businesses, both big and small. Savings banks, by and large, take money from savings accounts and loan it out as mortgages and car loans. Insurance companies take the premiums they receive and invest it, often in commercial banks, commodities and stocks making money twice, however they do occasionally pay on claims. When the claims paid out exceed the money an insurance company takes in or invests that is when they are in trouble. The more money they loan out they more they earn. That’s how they wrecking the economy and causing this suprime loan crisis.
How did the financial system collapse?
Various causes have been proposed for the crisis, with experts placing different weights upon particular issues. Fed Chairman Ben Bernanke summarized the crisis as follows during a January 2009 speech:
For almost a year and a half the global financial system has been under extraordinary stress—stress that has now decisively spilled over to the global economy more broadly. The proximate cause of the crisis was the turn of the housing cycle in the United States and the associated rise in delinquencies on subprime mortgages, which imposed substantial losses on many financial institutions and shook investor confidence in credit markets. However, although the subprime debacle triggered the crisis, the developments in the U.S. mortgage market were only one aspect of a much larger and more encompassing credit boom whose impact transcended the mortgage market to affect many other forms of credit. Aspects of this broader credit boom included widespread declines in underwriting standards, breakdowns in lending oversight by investors and rating agencies, increased reliance on complex and opaque credit instruments that proved fragile under stress, and unusually low compensation for risk-taking. The abrupt end of the credit boom has had widespread financial and economic ramifications. Financial institutions have seen their capital depleted by losses and writedowns and their balance sheets clogged by complex credit products and other illiquid assets of uncertain value. Rising credit risks and intense risk aversion have pushed credit spreads to unprecedented levels, and markets for securitized assets, except for mortgage securities with government guarantees, have shut down. Heightened systemic risks, falling asset values, and tightening credit have in turn taken a heavy toll on business and consumer confidence and precipitated a sharp slowing in global economic activity. The damage, in terms of lost output, lost jobs, and lost wealth, is already substantial.
The financial industry acts as a lubricant to the other industries. Other industries have expenses making their products and getting them to market and they earn profit when the products get to market and are sold. The financial industry comes into play because they loan money to the other industries making improvements and expansion possible but there is a negative effect when the debt increases the expenses or “overhead” reducing profit. Many companies, regardless of industry, go out of business when the profit drops below the expenses and most often at the root of the expenses exceeding profit is overwhelming debt. The debt holders have the right to demand the money they are owed in full when it becomes apparent to them that the company that owes them money cannot pay it back as agreed because the profit is exceeded by its expenses. When the debt holders (banks or private investors) demand their money or “call in the loans” and the company in debt doesn’t have the money that is when that company is wiped out or goes “bankrupt”.
If most of the loans a bank is holding go into default because the businesses or investors that took the loans can’t pay it back then the bank is in trouble.
That is what happened with the Real Estate market. Banks, Insurance companies, and private investors loaned out money recklessly to individuals to purchase houses they could not really afford assuming that value of the houses would continue to increase and if default occurred liquidation of the house would not only recover the money loaned out but possibly a profit because of the value of the house is increasing. What happened is that there were clusters of overvalued homes with defaulted loans dramatically dropping the value of all homes. The homes were not selling, the loans were not recovered, and the banks, insurance companies, and private investors woke up totally screwed.
What’s the government(the fed)’s position with the financial system and the economy?
The government controls credit markets because it loans out money to the banks in order for them to loan money to businesses and individuals. if the government (federal reserve bank) loans money to the banks at a high interest rate then banks in turn make loans at a higher interest rate. High interest rates discourage spending financed by loans. Low interest rates encourage spending financed by loans. Less spending drops the value of goods and services and more spending increases it.
The fed ==>loan(inject) to==>The financial systems(the banks) ==>loan to==>The economy (people, companies, and corporations.)
The fed and banks control the supply of the money and people and companies control the velocity of money.
Factors Which Increase the Demand for Money
1. A reduction in the interest rate.
2. A rise in the demand for consumer spending.
3. A rise in uncertainty about the future and future opportunities.
4. A rise in transaction costs to buy and sell stocks and bonds.
5. A rise in inflation causes a rise in the nominal money demand but real money demand stays constant.
6. A rise in the demand for a country’s goods abroad.
7. A rise in the demand for domestic investment by foreigners.
8. A rise in the belief of the future value of the currency.
9. A rise in the demand for a currency by central banks (both domestic and foreign).
Bernanke and Paulson are right, the U.S needs the most of those two giant stimulus package to help banks, but a bank reform is needed.
To stabilize financial system is the only way to get economy move again. if injecting most money into infrastructure and letting banks fall will cause depression. Businessmen need to borrow money to hire people. Building bridges, building and resident housing will not work. You can see the sign of “retail space is available” everywhere. If people can’t get the loan to do business in those retail space, economy won’t heat up again. Since we know most of the American companies are “expansion base on debt”, its very important to stabilize the financial system.
The government is also charged with purging criminality or more accurately unethical activity that could manipulate any industry and harm consumers. How effective the government is depends on who is in power. Republicans do not believe in any involvement of the government into private enterprises and therefore they pull back government regulation often to the point where the government is impotent as in the case of the FDA or SEC. In the case of the FDA that agency’s funding was peeled back until it could no longer function and in the case of the SEC executive decisions determined the level of regulation. Democrats believe that the private sector cannot be trusted to do right by consumers and increases regulation with the intention of putting more “cops on the beat” protecting consumers.
How do we reform the system and the solution for preventing the crisis like this?
–Source from Wikipedia
A variety of regulatory changes have been proposed by economists, politicians, journalists, and business leaders to minimize the impact of the current crisis and prevent recurrence. However, as of April 2009, many of the proposed solutions have not yet been implemented. These include:
* Ben Bernanke: Establish resolution procedures for closing troubled financial institutions in the shadow banking system, such as investment banks and hedge funds.[148]
* Joseph Stiglitz: Restrict the leverage that financial institutions can assume. Require executive compensation to be more related to long-term performance.[149] Re-instate the separation of commercial (depository) and investment banking established by the Glass-Steagall Act in 1933 and repealed in 1999 by the Gramm-Leach-Bliley Act.[150]
* Simon Johnson: Break-up institutions that are “too big to fail” to limit systemic risk.[151]
* Paul Krugman: Regulate institutions that “act like banks ” similarly to banks.[152]
* Alan Greenspan: Banks should have a stronger capital cushion, with graduated regulatory capital requirements (i.e., capital ratios that increase with bank size), to “discourage them from becoming too big and to offset their competitive advantage.”[153]
* Warren Buffett: Require minimum down payments for home mortgages of at least 10% and income verification.[154]
* Eric Dinallo: Ensure any financial institution has the necessary capital to support its financial commitments. Regulate credit derivatives and ensure they are traded on well-capitalized exchanges to limit counterparty risk.[155]
* Raghuram Rajan: Require financial institutions to maintain sufficient “contingent capital” (i.e., pay insurance premiums to the government during boom periods, in exchange for payments during a downturn.)[156]
* A. Michael Spence and Gordon Brown: Establish an early-warning system to help detect systemic risk.[157]
* Niall Ferguson and Jeffrey Sachs: Impose haircuts on bondholders and counterparties prior to using taxpayer money in bailouts. In other words, bondholders with a claim of $100 would have their claim reduced to $80, creating $20 in equity. This is also called a debt for equity swap. This is frequently done in bankruptcies, where the current shareholders are wiped out and the bondholders become the new stockholders, agreeing to reduce the company’s debt burden in the process. This is being done with General Motors, for example.[158][159]
* Nouriel Roubini: Nationalize insolvent banks.[160] Reduce mortgage balances to assist homeowners, giving the lender a share in any future home appreciation.[161]
Most people believe study in finance will get them to earn the most money and it’s true because banksters, traders, brokers will try everything they can to get the money out of ordinary people: CDs, mortgage backed by security, insurance, bonds, anything that can earn interest or premium out of your pocket.
Why do we need use the corrupted financial system to keep credit available for real people and businesses? Why should we provide the stakes for losing gamblers to keep gambling? Why not just make credit directly available to the real-world economy and re-enact safeguards to keep this casino-like financial system from poisoning it? Banks are important, but they have to do it right. Putting our taxpayers’ money into banks to fill their hold in the books is needed, but a major innovation is also necessary.
Alex, Mai
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