Tuesday, March 17, 2015

2008 Housing Bubble: Four Popular Tools to Solve the Economic Crisis

In addition to bailout, the US government took four more tools from its arsenal to solve the financial crisis. Prohibition on short-selling is the first of these four.

Short-selling is the exact opposite of "buy low and sell high" strategy used by investors. Instead, traders "sell high and buy low" and they do this by borrowing stocks from a broker and sell them from their perceived "overvalued" price and buy them again when the price is down. These traders then return the borrowed stocks and keep the gain for themselves.

Thomas Woods is opposed to this kind of restriction. He thinks that traders are doing service to investors by giving them important information about sound firms. Without this information, investors might place their money on unsound firms. This wastes scarce resources and deprives sound companies of the necessary funds to finance their projects. 

Regulators do not like short-sellers for the latter exposed their failure to do their job to identify companies, which resort to fraudulent accounting practices to exaggerate profitability and fool investors. This is the reason why short-sellers are doing great service for the good of economy by alarming investors. 

Another tool to aid the economy was the increase of insurance of depositors' money "from $100,000 to $250,000" "without considering the soundness of the bank's finances" (p. 45). For Woods, this was an additional "layer of moral hazard" for such action on the part of the FDIC removes from the banks the "need to become more cautious and conservative" (ibid.). Woods notes that in reality, the FDIC can only insure .5% of all the depositors' money. And so in case banking crisis occurs, the ultimate solution is to return to the old trick of printing USD. 

Still another solution was "foreclosure holidays" (p. 46). For Woods, this would aggravate the problem for this would entice the marginal borrowers to stop their mortgage payments. This would result to lesser credit, thereby depriving the common man to avail a mortgage loan, an unfortunate outcome that will be blamed on free market's "inefficiency".

And finally, we come to more regulation. For Woods, it is crucial to understand the basic framework how this talk on regulation and deregulation is taking place, which is the act of transfering the risk of unsound companies to taxpayers. Woods indicates that this debate on "deregulation" is actually anomalous for how can one talk of it when the government allows firms to make riskier investments with the guarantee of taxpayers' money. This is not deregulation. Genuine deregulation entails the removal of monopoly and free competition. For Woods, the real problem is "a system that artificially encourages indebtedness, excessive leverage, and reckless money management" (p. 47). And so the passing of Sarbanes-Oxley, which demands higher financial requirement from firms would actually prevent the creation of new firms. This would protect big firms from competititon and that's why Woods believes that they would join the "choir" of those who are singing for more government regulation. Woods agrees with Michael S. Malone that this kind of regulation would result into further economic anomalies. Quoting Malone, Woods describes these results:

"'. . . fewer new companies are going public; economic power is being concentrated in the hands of fewer companies; competition is reduced; new wealth is less widely distributed; the rich are getting richer; fewer talented people want to join entrepreneurial ventures; and corporate boards are getting more stupider and more paranoid'" (p. 48). 

Guide Questions:

1. Enumerate the five mainstream solutions to economic crisis. Briefly explain each.

2. Why is it that restricting short-sellers would harm the economy?

3. Are depositors' money completely safe in the bank? How many % of it is actually insured. How can FDIC keep its insurance policy in case of a bank collapse?

4. How would foreclosure holidays shift the blame to free market?

5. Identify the long-term results of more government regulation. 

Source: Wood, T. E. Jr. (2009). Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse. Washington, DC: Regnery Publishing, Inc.