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Causes of the World Financial Meltdown?Views: 906
Jun 22, 2009 6:08 amCauses of the World Financial Meltdown?#

John Stephen Veitch
These are some quotes from
"Obama's False Financial Reform" by William Greider
Published today in Common Dreams.

Barack Obama .... tried to make it sound as though everyone was implicated in the financial breakdown and therefore no one was really to blame. "A culture of irresponsibility took root from Wall Street to Washington to Main Street," Obama explained. "And a regulatory system basically crafted in the wake of a 20th century economic crisis--the Great Depression--was overwhelmed by the speed, scope and sophistication of a 21st century global economy."

That is not what happened, to put it charitably.

The regulatory system was ... systematically gutted and dismantled by the government in Washington at the behest of the banking interests. If Obama wants details, he can consult his economic advisors--Summers-Geithner--who participated directly as accomplices in unwinding the prudential rules and regulations. Cheers were led by the Federal Reserve with heavy lifting by both political parties.

If Obama were to tell the truth now about what went wrong in the financial system, he would face a far larger political problem trying to clean up the mess.

Congress doesn't much want to face the music either. In the long run, [this neglect] will haunt the country because it fails to confront the true nature of the disorders.

Asking the cloistered Federal Reserve to resolve all the explosive questions about the over-reaching power of financial institutions is like throwing the problem into a black box and closing the lid, so people will be unable to see what happens next. ... Give the mess to the Wizard of Oz, the guy behind the curtain. He can do miracles with money, but don't watch too closely. This constitutes the high politics of evasion.

Still, I am thrilled to observe a nascent rebellion gathering strength in Congress. ... Even House Speaker Nancy Pelosi expressed concern (and gave a nice plug for my 1987 book about the Fed). "The fact is that the American people want to know more of the Secrets of the Temple," she said. If they do learn more, I guarantee shock and awe will grow into outrage.

Outrage is good. ... The power of financial titans and their friends at the Fed depends crucially on public ignorance. Most elected representatives and senators are just as clueless as their constituents. This is not entirely their fault. The system is designed to encourage deference to murky power.

Several times in the last two decades the Fed and other central banks enacted new and supposedly more effective capital requirements to curb the excesses. The big dogs of banking broke free of the leash again and again while vigilant watchdogs at the Fed and elsewhere looked the other way. Why should we expect different results next time?

One reason why old restraints failed is the so-called "modernization" that shifted the credit functions outside regulated banks and into a variety of unregulated money pots--the so-called shadow banking system of hedge funds and private-equity firms. These all interact intimately with traditional banks and give the banks profitable ways to evade the old rules or conceal the actual condition of their balance sheets from both regulators and innocent investors. This was not an accident of nature. It was the goal of financial deregulation enacted by Bill Clinton, arm-in-arm with the Republican Congress.

Likewise, banks were allowed to play these games by legislative creation of "off-balance sheet entities" where they can park their holdings--debts or assets--beyond the view of casual observers. This is essentially the same accounting trick that empowered Enron and other corporations to hide their true condition (then collapse).

The biggest bankers played roughly the same game. In fact, it was the bankers who taught Enron and others these tricks. What public purpose is served by these devices except to conceal reality from public investors?

What is the public purpose of letting corporations, banks and wealthy individuals park their wealth in the Grand Cayman Islands? Everyone in Wall Street knows the answer. It allows them to evade "legally" US regulations and tax law.

Summers-Geithner suggest that the Fed will watch [financial institutions] (we are assured) to prevent "systemic risk" that could lead to national breakdown. But that is what the Federal Reserve was supposed be doing already as the "lender of last resort" charged with defending the "safety and soundness" the banking system.

The Securities and Exchange Commission, likewise, is supposed to monitor hedge funds and private-equity firms that thrive on secrecy. Since the SEC failed miserably to police regular corporations, it does not sound reassuring.

The method of bundling home mortgages and turning them into saleable bonds was supposed to reduce risk but did the opposite. The mortgage lenders were able to execute dubious, even fraudulent loans, collect their profits up front and then sell the package to unwitting investors around the world.

You cannot design organic reforms until you understand what really led to the breakdown. Since the government has avoided that kind of serious examination, the limp response is to turn these explosive issues over to expert regulators--the same experts who failed to see the trouble coming.

Right now, I think the political imperative is to slow down the rush to weak solutions. ... Congress would do well to drag its feet and insist instead on deeper investigations.

Give subpoena power to Elizabeth Warren the Congressional Oversight Board she chairs. Hire some of those investigative reporters who have no political investment in digging deeper into the mulch. What exactly went wrong? Who has bloody hands? Where are the fundamental reforms?

Copyright © 2009 The Nation

William Greider is national affairs correspondent for The Nation. He is author of "Secrets of the Temple: How the Federal Reserve Runs the Country" and, most recently, "Come Home, America: The Rise and Fall (and Redeeming Promise) of Our Country."

John Stephen Veitch
Open Future Limited - http://www.openfuture.biz/
Innovation Network - http://veech-network.ryze.com/
Building an Open Future - http://openfuture-network.ryze.com/

Private Reply to John Stephen Veitch

Jun 22, 2009 6:22 amre: Causes of the World Financial Meltdown?#

Alan Walsh
Even more fundamentally than gutting the financial regulatory system, the Fed & the Treasury collaborated in the massive money creation (and consequent debt creation) that fed the deregulated monster they created. That same policy of "printing their way out of trouble" is being exercised now; with massive current & future consequences to come. The Fed, a private bank run by bankers for the benefit of bankers, should be shut down.

Private Reply to Alan Walsh

Jun 22, 2009 5:54 pmre: Causes of the World Financial Meltdown?#

Thomas Holford
John sayeth:

(Quoting William Greider)

> The regulatory system was ... systematically gutted and dismantled by the government in Washington at the behest of the banking interests. If Obama wants details, he can consult his economic advisors--Summers-Geithner--who participated directly as accomplices in unwinding the prudential rules and regulations. Cheers were led by the Federal Reserve with heavy lifting by both political parties.

> If Obama were to tell the truth now about what went wrong in the financial system, he would face a far larger political problem trying to clean up the mess.

> Congress doesn't much want to face the music either. In the long run, [this neglect] will haunt the country because it fails to confront the true nature of the disorders.

> Asking the cloistered Federal Reserve to resolve all the explosive questions about the over-reaching power of financial institutions is like throwing the problem into a black box and closing the lid, so people will be unable to see what happens next. ... Give the mess to the Wizard of Oz, the guy behind the curtain. He can do miracles with money, but don't watch too closely. This constitutes the high politics of evasion.

Notwithstanding that this appeared in the crazy leftwing looney bin Nation magazine, I don't know that I necessarily disagree with any of it. (I feel like a cheap and dirty sell-out).

I also like the analysis of Thomas Woods in his book "Meltdown", in which he places the biggest part of the blame on the Federal Reserve and it's fiat money system.

Woods also blames the cheap credit policies which kept interest rates down, expanded the money supply, and fundamentally caused the economy's unstable "boom and bust" cycles.

Political stupidity, opportunism, corruption, and perfidy on the part of people like Franklin Roosevelt, Harry Truman, Jimmy Carter, Bill Clinton, Franklin Raines, Jameie Gorelick, Chris Dodd, Bawney Fwank, etc. etc. just made things worse.

I'm sure there were Republicans, too, who joined in the orgy, but Republican politicians tend to be followers who just want to get along and do what the Democrats do, just not so much of it.

I'm also sure that people will be writing books and explaining the financial debacle for decades, and there will be a large buffet of conspiracy theories and villains to choose from.

Thomas Holford

Private Reply to Thomas Holford

Jul 10, 2009 2:22 amre: re: Causes of the World Financial Meltdown?#

John Stephen Veitch
This URL prints to about 13 pages, I'll give you only the first page or so below. While I believe the problem with our markets goes back to Reagan and Thatcher (and Douglas and Richardson in New Zealand) Matt Taibbi puts the problem squarely in Bill Clinton's patch, naming Robert Rubin (Who's economic ideas I actually quite like) as the main culprit. I guess my ideas on Rubin are coloured by my training, free markets appear to be a good idea. Until you read what Taibbi writes.


The Great American Bubble Machine

From tech stocks to high gas prices, Goldman Sachs has engineered every major market manipulation since the Great Depression - and they're about to do it again

By Matt Taibbi

July 09, 2009 "Rolling Stone" -- July 02, 2009 --- The first thing you need to know about Goldman Sachs is that it's everywhere. The world's most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money. In fact, the history of the recent financial crisis, which doubles as a history of the rapid decline and fall of the suddenly swindled-dry American empire, reads like a Who's Who of Goldman Sachs graduates.

By now, most of us know the major players. As George Bush's last Treasury secretary, former Goldman CEO Henry Paulson was the architect of the bailout, a suspiciously self-serving plan to funnel trillions of Your Dollars to a handful of his old friends on Wall Street. Robert Rubin, Bill Clinton's former Treasury secretary, spent 26 years at Goldman before becoming chairman of Citigroup - which in turn got a $300 billion taxpayer bailout from Paulson. There's John Thain, the rear end in a top hat chief of Merrill Lynch who bought an $87,000 area rug for his office as his company was imploding; a former Goldman banker, Thain enjoyed a multibillion-dollar handout from Paulson, who used billions in taxpayer funds to help Bank of America rescue Thain's sorry company. And Robert Steel, the former Goldmanite head of Wachovia, scored himself and his fellow executives $225 million in golden parachute payments as his bank was self-destructing. There's Joshua Bolten, Bush's chief of staff during the bailout, and Mark Patterson, the current Treasury chief of staff, who was a Goldman lobbyist just a year ago, and Ed Liddy, the former Goldman director whom Paulson put in charge of bailed-out insurance giant AIG, which forked over $13 billion to Goldman after Liddy came on board. The heads of the Canadian and Italian national banks are Goldman alums, as is the head of the World Bank, the head of the New York Stock Exchange, the last two heads of the Federal Reserve Bank of New York - which, incidentally, is now in charge of overseeing Goldman - not to mention ...

But then, any attempt to construct a narrative around all the former Goldmanites in influential positions quickly becomes an absurd and pointless exercise, like trying to make a list of everything. What you need to know is the big picture: If America is circling the drain, Goldman Sachs has found a way to be that drain - an extremely unfortunate loophole in the system of Western democratic capitalism, which never foresaw that in a society governed passively by free markets and free elections, organized greed always defeats disorganized democracy.

The bank's unprecedented reach and power have enabled it to turn all of America into a giant pump-and-dump scam, manipulating whole economic sectors for years at a time, moving the dice game as this or that market collapses, and all the time gorging itself on the unseen costs that are breaking families everywhere - high gas prices, rising consumer-credit rates, half-eaten pension funds, mass layoffs, future taxes to pay off bailouts. All that money that you're losing, it's going somewhere, and in both a literal and a figurative sense, Goldman Sachs is where it's going: The bank is a huge, highly sophisticated engine for converting the useful, deployed wealth of society into the least useful, most wasteful and insoluble substance on Earth - pure profit for rich individuals.

They achieve this using the same playbook over and over again. The formula is relatively simple: Goldman positions itself in the middle of a speculative bubble, selling investments they know are crap. Then they hoover up vast sums from the middle and lower floors of society with the aid of a crippled and corrupt state that allows it to rewrite the rules in exchange for the relative pennies the bank throws at political patronage. Finally, when it all goes bust, leaving millions of ordinary citizens broke and starving, they begin the entire process over again, riding in to rescue us all by lending us back our own money at interest, selling themselves as men above greed, just a bunch of really smart guys keeping the wheels greased. They've been pulling this same stunt over and over since the 1920s - and now they're preparing to do it again, creating what may be the biggest and most audacious bubble yet.

If you want to understand how we got into this financial crisis, you have to first understand where all the money went - and in order to understand that, you need to understand what Goldman has already gotten away with. It is a history exactly five bubbles long - including last year's strange and seemingly inexplicable spike in the price of oil. There were a lot of losers in each of those bubbles, and in the bailout that followed. But Goldman wasn't one of them.


Much more here:

John Stephen Veitch
Open Future Limited - http://www.openfuture.biz/
Innovation Network - http://veech-network.ryze.com/
Building an Open Future - http://openfuture-network.ryze.com/

Private Reply to John Stephen Veitch

Jul 10, 2009 6:33 amre: re: re: Causes of the World Financial Meltdown?#

Thomas Holford
John sayeth:

> "What you need to know is the big picture: If America is circling the drain, Goldman Sachs has found a way to be that drain - an extremely unfortunate loophole in the system of Western democratic capitalism, which never foresaw that in a society governed passively by free markets and free elections, organized greed always defeats disorganized democracy."

Goldman Sachs is probably one of the major "owners" of the supposedly politically isolated "Federal Reserve System".

Libertarians and Austrian school economists have long been declaiming to anyone who would listen that the Federal Reserve is A.) unconstitutional, B.) perfidious, malignant, destructive, and any other invective you can think of.

If your point is that Goldman Sachs enriched itself immorally, unethically, and at the expense of the American people, I will have a hard time mounting any kind of defense in Goldman's behalf.

If your point is that all of Goldman's perfidy would have been prevented and sweetness and light would have blessed all the people across the land if we would have just had some Marx thumping commies running the economy, I will disagree.

The free market is founded on the premise that a free market monetary system is an essential element of a free market economy.

A "market economy" based on a politician directed fiat money monopoly is no free market. It is a poor man's centrally planned economy lacking only the industrial commissars.

But now that The Obamagogue is the Commissar of the U.S. Auto Industry, and has THIRTY-TWO other designated Czars, the U.S. will be a centrally planned economy faster than you can say "Goldman Sachs Public-Private Partnership".

I'm sure that Goldman Sachs and George Soros probably take turns writing the stuff that appears on Obama's teleprompter.

T. Holford

Private Reply to Thomas Holford

Jul 10, 2009 1:20 pmre: re: re: re: Causes of the World Financial Meltdown?#

Matthew Hartstein
The main reason that we had this crash is the fact that the United States people, corporations, and government gorged themselves on DEBT for too long and once people wised up to the fact that there was too much debt especially from individuals and corporations we had a credit crisis.

Matthew Hartstein

Private Reply to Matthew Hartstein

Jul 10, 2009 2:27 pmCauses of the World Financial Meltdown? 3 words:#

Mike Fesler BizHarmony

Apathy: in the general public and the job sector of the government. People in the general public that do not ask questions, they are actually thinking that the government will be a good thing and they will watch out for their best interests? People within the government that are holding positions that are not doing their job. With -0- accountability on back to them.

Entitlement: In the general public and the government. People think that they are entitled to happiness, and the American dream. If they can not get it (Achieve = work for it) themselves. . . then it falls to the government to provide.

Greed: Private and government sectors have manipulated the system and used and abused others to benefit themselves beyond the normal.

The only level playing field is now in the history books, the American dream has now been taken away by sudo-socialism. The slippery slope has now become a cliff, simply to the fact that the multitudes have not woke up to the theft of their dream.

So when it comes to fault? We are all at fault.
You get what you pay for.
You get what you vote for.
You get what you deserve.

Resolve not to be poor: whatever you have, spend less. Poverty is a great enemy to human happiness; it certainly destroys liberty, and it makes some virtues impracticable, and others extremely difficult. - Samuel Johnson


Private Reply to Mike Fesler BizHarmony

Jul 23, 2009 5:20 amre: Causes of the World Financial Meltdown?#


Thomas Jefferson clearly saw what a central bank would do to US. He realized that if a central bank was ever set up, the bankers would have unlimited amounts of money to manipulate how lawmakers voted, these bankers would find it necessary to rewrite the constitution for their own benefit. He said,

A private central bank issuing the public currency is a greater menace to the liberties of the people than a standing army. -Thomas Jefferson

To convince people a great need for a central bank and that was for their protection, they also use bank failures to create a popular demand for monetary reform and to not call the fed a central bank and make it appear like a gov't agency.

It seems that they lend money they know would bury the borrower in debt.

This is the largest theft ever.

Greedy people gives hopelessness to other people.

Private Reply to Designe

Jul 28, 2009 5:42 pmre: re: Causes of the World Financial Meltdown?#

Lamar Morgan 954-603-7901

Gov. Schwarzenegger is going to have his Second Annual Small Business Conference in San Francisco on November 19th. I am asking Marty Keller, Small Business Advocate for the State of California to allow me - with the help of high school students - to encourage attendance for this event. I have access to the Forbes list of the wealthiest of Californians and would like to use it to create some much-needed "buzz" for this event.

Here is what I want to do. I want to have high school students create a special paperweight, include it in a box with a letter to the wealthy person via his company. The paperweight will be a desk reminder of the conference. The letter will be a personal request from the student. For the student's participation he will receive community credit toward high school graduation. But, where does the money come from to mail the package? I am thinking about doing Ebay auctions for each package. People will actually bid, for example, to be the person who makes little Johnny's package get mailed to Steve Jobs or George Lucas - whichever person he designed the paperweight for. Basically, the bidding would start at the minimum for mailing the package and go up. All profit would go to the school. The artwork from the students could actually go on display at a local Thursday market that runs throughout the summer...until the end of October.

Well, if the local school superintendent goes for it, do you think this is a good idea or has inherent flaws? For example, no one bothers to bid on the student effort?

What about the content for the enclosed letters? Well, for that, I was thinking about connecting the students up with comments from Ryzers who want to help California get out of its economic mess. I am not asking for money. I am asking for words...advice from caring people around the world that young people can freely choose to echo. Anyone interested?

Lamar Morgan
CDMM - Synergistic Business Marketing
Need PR?...Call Lamar!

Private Reply to Lamar Morgan 954-603-7901

Jul 29, 2009 1:57 amre: Causes of the World Financial Meltdown?#

James Booth
How truly bizarre seems an argument that we must either have a Communist system, or instead, "tolerate" the "perfidy" (how very polite) of the likes of Goldman Sachs taking advantage of a "free" market, which of course is not free at all considering how much government regulation / deregulation / reregulation – in short, *manipulation* - is involved ...

Or my reading comprehension fails

... as if there were, or could be, no alternate possibility.

The very existence of a fiat currency, even if it were "legitimately" issued by a government, is manipulation of a worst kind – one which limits transactions among individual, otherwise free, men and women, to use of "legal tender" only.

Imperial currency, "coin of the realm" – a way to impose hidden taxes.

Sure, we are almost all of us guilty of gorging ourselves on debt, or abandoning dead men's values in exchange for an "end-of-the-world" orgy, but not without "guidance from above" – not without, for instance, repeal of Glass Steagall.

To blame the current global greatest of all economic depressions on The People is to admit ignorance, unless one is a shill of the central bank and its cronies.

The main reason "there was too much debt" resulted from ending the Gold Standard and creating a debt-based economy.

"You get what you pay for.
You get what you vote for.
You get what you deserve."

Easy to say if one still suffers any delusion there is wealth among The People with which to pay, or that they can challenge the obscene amounts "contributed" to campaign coffers by certain corporate entities; if one still thinks their act of voting actually elects anyone, with possible exception of local races; only in the act of trusting elected and appointed officials and other "office holders" to honour their contracts and do what is moral does anyone in the public "get what they deserve" for not calling the crooks to account and locking them away as the ordinary, or sometimes not-so-ordinary, criminals they are.


Private Reply to James Booth

Jul 29, 2009 11:07 pmre: re: Causes of the World Financial Meltdown?#

Ron Sam

Why Economists Failed to Predict the Financial Crisis

There is a long list of professions that failed to see the financial crisis brewing. Wall Street bankers and deal-makers top it, but banking regulators are on it as well, along with the Federal Reserve. Politicians and journalists have shared the blame, as have mortgage lenders and even real estate agents.

But what about economists? Of all the experts, weren't they the best equipped to see around the corners and warn of impending disaster?

Indeed, a sense that they missed the call has led to soul searching among many economists. While some did warn that home prices were forming a bubble, others confess to a widespread failure to foresee the damage the bubble would cause when it burst. Some economists are harsher, arguing that a free-market bias in the profession, coupled with outmoded and simplistic analytical tools, blinded many of their colleagues to the danger.

"It's not just that they missed it, they positively denied that it would happen," says Wharton finance professor Franklin Allen, arguing that many economists used mathematical models that failed to account for the critical roles that banks and other financial institutions play in the economy. "Even a lot of the central banks in the world use these models," Allen said. "That's a large part of the issue. They simply didn't believe the banks were important."

Over the past 30 years or so, economics has been dominated by an "academic orthodoxy" which says economic cycles are driven by players in the "real economy" -- producers and consumers of goods and services -- while banks and other financial institutions have been assigned little importance, Allen says. "In many of the major economics departments, graduate students wouldn't learn anything about banking in any of the courses."

But it was the financial institutions that fomented the current crisis, by creating risky products, encouraging excessive borrowing among consumers and engaging in high-risk behavior themselves, like amassing huge positions in mortgage-backed securities, Allen says.

As computers have grown more powerful, academics have come to rely on mathematical models to figure how various economic forces will interact. But many of those models simply dispense with certain variables that stand in the way of clear conclusions, says Wharton management professor Sidney G. Winter. Commonly missing are hard-to-measure factors like human psychology and people's expectations about the future, he notes.

Among the most damning examples of the blind spot this created, Winter says, was the failure by many economists and business people to acknowledge the common-sense fact that home prices could not continue rising faster than household incomes.

Says Winter: "The most remarkable fact is that serious people were willing to commit, both intellectually and financially, to the idea that housing prices would rise indefinitely, a really bizarre idea."

Although many economists did spot the housing bubble, they failed to fully understand the implications, says Richard J. Herring, professor of international banking at Wharton. Among those were dangers building in the repo market, where securities backed by mortgages and other assets are used as collateral for loans. Because of the collateralization, these loans were thought to be safe, but the securities turned out to be riskier than borrowers and lenders had thought.

The Dahlem Report

In a highly critical paper titled, "The Financial Crisis and the Systemic Failure of Academic Economists," eight American and European economists argue that academic economists were too disconnected from the real world to see the crisis forming. The authors are David Colander, Middlebury College; Hans Follmer, Humboldt University; Armin Haas, Potsdam Institute for Climate Impact Research; Michael Goldberg, University of New Hampshire; Katarina Juselius, University of Copenhagen; Alan Kirman, University d'Aix-Marseille; Thomas Lux, University of Kiel; and Brigitte Sloth, University of Southern Denmark.

"The economics profession appears to have been unaware of the long build-up to the current worldwide financial crisis and to have significantly underestimated its dimensions once it started to unfold," they write. "In our view, this lack of understanding is due to a misallocation of research efforts in economics. We trace the deeper roots of this failure to the profession's insistence on constructing models that, by design, disregard the key elements driving outcomes in real world markets."

The paper, generally referred to as the Dahlem report, condemns a growing reliance over the past three decades on mathematical models that improperly assume markets and economies are inherently stable, and which disregard influences like differences in the way various economic players make decisions, revise their forecasting methods and are influenced by social factors. Standard analysis also failed, in part, because of the widespread use of new financial products that were poorly understood, and because economists did not firmly grasp the workings of the increasingly interconnected global financial system, the authors say.

One result of this, argues Winter, who is not one of the authors but agrees with much of what they say, is to build into models an assumption that all market participants -- bankers, lenders, borrowers and consumers -- behave rationally at all times, as if they were economists making the most financially favorable choices. Clearly, he says, rational behavior is not that dependable, or else people would not do self-destructive things like taking out mortgages they could not afford, a key factor in the financial crisis. Nor would completely rational executives at financial firms invest in securities backed by those risky mortgages, which they did.

By relying so heavily on the view of humans as rational, the paper's authors argue, economists ignore evidence of irrational behavior that is well documented in other disciplines like psychology and sociology. Even if an individual does act rationally, economists are wrong to assume that large groups of people will react to given conditions as an individual would, because they often do not. "Economic modeling has to be compatible with insights from other branches of science on human behavior," they write. "It is highly problematic to insist on a specific view of humans in economic settings that is irreconcilable with evidence."

The authors say economists badly underestimated the risks of new types of , which are financial instruments whose value fluctuates, often to extremes, according to the changing values of underlying securities. Traditional such as stock options and commodities futures are well understood. But exotic devised in recent years, including securities built upon pools of mortgages, turned out to be poorly understood, the authors say. Credit default swaps, a form of derivative used to insure against a borrower's failure to repay a loan, played a key role in the collapse of American International Group.

Rather than accurately analyzing the risks posed by new , many economists simply fell back on faith that creating new financial products is good, the authors write. According to this belief, which was promoted by former Federal Reserve chairman Alan Greenspan, a wider variety of financial products allows market participants to place ever more refined bets, so the markets as a whole better reflect the combined wisdom of all the players. But because there was not enough historical data to put into models used to price these new , risk and return assessments turned out to be wrong, the authors argue. These securities are now the "toxic assets" polluting the balance sheets of the nation's largest banks.

"While the economic argument in favor of ever new is more one of persuasion rather than evidence, important negative effects have been neglected," they write. "The idea that the system was made less risky with the development of more led to financial actors taking positions with extreme degrees of leverage, and the danger of this has not been emphasized enough."

'Control Illusion'

When certain price and risk models came into widespread use, they led many players to place the same kinds of bets, the authors continue. The market thus lost the benefit of having many participants, since there was no longer a variety of views offsetting one another. The same effect, the authors say, occurs if one player becomes dominant in one aspect of the market. The problem is exacerbated by the "control illusion," an unjustified confidence based on the model's apparent mathematical precision, the authors say. This problem is especially acute among people who use models they have not developed themselves, as they may be unaware of the models' flaws, like reliance on uncertain assumptions.

Much of the financial crisis can be blamed on an overreliance on ratings agencies, which gave complex securities a seal of approval, says Wharton finance professor Marshall E. Blume. "The ratings agencies, of course, use models" which "grossly underestimated" risks.

"Any model is an abstraction of the world," Blume adds. "The value of a model is to provide the essence of what is happening with a limited number of variables. If you think a variable is important, you include it, but you can't have every variable in the world.... The models may not have had the right variables."

The false security created by asset-pricing models led banks and hedge funds to use excessive leverage, borrowing money so they could make bigger bets, and laying the groundwork for bigger losses when bets went bad, according to the Dahlem report authors.

At the time, few people knew that major financial institutions had become so heavily leveraged in real estate-related assets, says Wharton finance professor Jeremy J. Siegel. "Had they not been in that situation, we would not have had the crisis," he says. "We may not even have had a recession.... Macro economists really hadn't talked about it because these structured financial products were relatively new," he adds, arguing that economists will have to scrutinize the balance sheets of major financial institutions more closely to detect mushrooming risks.

Lessons Not Learned

Prior to the latest crisis, there were two well-known occasions when exotic bets, leverage and inadequate modeling combined to create crises, the paper's authors say, arguing that economists should therefore have known what could happen. The first case, the stock market crash of 1987, began with a small drop in prices which triggered an avalanche of sell orders in computerized trading programs, causing a further price decline that triggered more automatic sales.

The second case was the 1998 collapse of the Long-Term Capital Management (LTCM) hedge fund. It had built up a huge position in government bonds from the U.S. and other countries, and was forced into a wave of selling after a Russian government bond default knocked bond prices down.

"When there's a default in one kind of bond, it causes reassessment of all the risks," says Wharton economics professor Richard Marston. "I don't think we have really fully learned from the LTCM crisis, or from other crises, the extent to which things are illiquid." These crises have shown that market participants can rely too heavily on the belief they can quickly unload securities that decline in price, he says. In fact, the downward spiral can be so rapid that it leaves investors with losses far larger than they had thought possible.

In the current crisis, he says, economists "should get blamed for the overall unwillingness to take into account liquidity risk. And I think it's going to force us to reassess that."

Academics also are beginning to reassess business-school curricula. Wharton management professor Stephen J. Kobrin recently moderated a faculty panel that talked about a wide range of possible responses to the crisis. Among the issues discussed, he says, was whether Wharton's curriculum should include more on regulation and risk management, as well as executive education programs for regulators and other government officials.

Kobrin said he believes many academics share "an ideological fixation with free markets and lack of regulation" that should be reexamined. "Obviously, people missed the boat on a lot of the risks that a lot of financial instruments entailed," he says. "We need to think about what changes are needed in the curriculum."

Published: May 13, 2009 in Knowledge@Wharton

Private Reply to Ron Sam

Jul 29, 2009 11:20 pmre: re: re: Causes of the World Financial Meltdown?#

Ron Sam
The Size of Derivatives Bubble = $190K Per Person on Planet - SiliconValleyWatcher

JPMorgan Said to Reap $5 Billion Derivatives Profit

Private Reply to Ron Sam

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