Why the bubble burst
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Analysis of the factors that led to the current financial crisis and the need for stringent regulation
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PANIC — The Story of Modern Financial Insanity: Edited by Michael Lewis; Penguin Books India Pvt. Ltd., 11, Community Centre, Panchsheel Enclave, New Delhi-110017. Rs.250.
S. L. Rao
This is a very timely book, appearing as it does in the midst of a global economic slowdown (termed “recession” in some countries; some say it is already a “depression” in the U.S.). While timely, it is also confusing, containing as it does a collection of articles that have appeared at different times by many authors (seven by Michael Lewis whose claim to fame is as the author of Liar’s Poker about the Wall Street in the 19
80s). The writing varies in quality, sometimes tedious, and in other cases gripping. The 14-page special report on the future of finance in The Economist (January 24-30, 2009) gives a much more cogent explanation of what has gone wrong over the years.
Lessons
Lewis divides the book into four parts basically discussing the four major financial crises of the last 25 years, the bursting of the internet bubble, the Asian currency crisis, the Russian government bond default that triggered the failure of the hedge fund Long-Term Capital Management, and the current crisis that began with the housing bubble in the U.S., which was a result of massive foreign funds entering the U.S., leading to low interest rates.
I will not explain each of these crises but shall extract some of the lessons from interesting observations by different writers. Stephen Lebaton quotes a small investor who says, “I finally realized that this is a gambling business...it is not a place for small and medium investors. Today large companies loaded with cash are making a killing while we can’t possibly compete.”
Lester C. Thurow points to the difference made by information technology and instant communications. It led to the development of two kinds of programme trading: stock-index arbitrage and portfolio insurance. The first depends on discrepancies between current and futures prices of stocks in different exchanges. The computer is programmed so that whenever the differential in price between the Standard and Poor 500-stock index and the “futures index” of the same stocks reaches a certain point, the computer automatically issues orders to buy and sell. Portfolio insurance is to protect institutional investors from losses on the stock market. The computer is programmed to buy and sell index futures (contracts to deliver or buy stocks at a later date at a given price) whenever stock prices rise or fall. But the computer responds only to events that have already happened and acts according to the rules built into the programme by the broker.
Supervision
Terri Thompson points to the lack of consistent regulatory supervision. She says that most reformers like the idea of “circuit breakers” (used in India) when there are coordinated halts to trading in all exchanges when the market rises or falls beyond a certain number of points in a day. As George Soros, the best-known foreign exchange speculator, says in an interview by Ron Johnson, “When you are involved in large-scale speculation, there are very real consequences.” Michael Lewis adds that “The veneer of official authority is not as important in the global financial system as the power to gain and hold the attention of Bloomberg World—the hundred thousand or so traders, bankers, investors and analysts attached to Bloomberg terminals.”
India in the middle of today’s recession must reflect on Jeffrey Sachs’ saying that to live on hot money will lead to regret some years later when banks yank their money. Joseph Stiglitz concludes that “there is a need for a credible international financial institution to design the rule of the road in ways that enhance global stability and promote economic growth in developing countries.”
Tougher regulation
Michael Lewis points out that with hedge funds, “The old wall between the trading floor and the research department had been pulled down.” Financial markets spawned “vastly complicated new instruments-options, futures, swaps, mortgage bonds and more.” The use of mathematical models and computer programmes led to the intellectual approach in finance and completely baffled laypeople, and regulators. Richard Meislin says that there was a shift in values among people who now seemed to find it difficult to distinguish between self worth and net worth.
What this collection, provided you have the patience and concentration to read and understand the volume, shows is that hot money stimulating economies, decline in savings in developed economies, the failure of regulators, the unbridled freedom to financial operators to create more and more complex products, the dominance of greed over ethics, the entry of intellectual young men with mathematical models, the rise of computer programmes, and the speed of movement of money across borders, all joined to create a disconnect from the real world leading to the inevitable collapse. It has to lead to worldwide regulation of finance by an International Monetary Fund (IMF) type regulator, the suppression of unbridled greed and, much tougher and more competent national financial regulation.
This is a book for the financially literate, not for the layman.
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