Saturday, July 9, 2011

Finance Is Not A Free Market

If we look at Financial institutions the constant claim is that they are private companies and should not be heavily regulated. But this is simply wrong.

We can argue till we are blue in the face that regulating is good for the economy, but this is irrelevant. We are ignoring the role of the Federal Reserve. If the economy heats up, the Fed raises interest rates and when it slows down, it lowers them. When there is a rise in the value of a currency, the treasury prints more money. But why do this if the market is always right? Because financial institutions are not private corporations. They are publicly funded private/public partnerships. The way it works is like this.

Banks try to make obscene amounts of money any way they can. When they make too much, the Feds come in to modify the economy in some fashion to slow runaway growth. When they make too much, the Feds give them money for free.

OK. Here's one example of how this works, or I should say doesn't work. The economy slows down and the Feds lower the rate for BANKS. Not for everybody, only banks. This means that banks can make more money if they loan more money. But then there is a wall. What happens if the Feds cut rates as much as they can and it still is not enough? Liquidity trap. Banks borrow money at almost no interest or even zero interest. But if the economy is so bad there is no point in lending for profit, banks look for old debt that paid more and they buy that.

A bank gets free money so it can lend to an economy that is desperate for investments. But it says instead...

You know all those bonds that were issued in the days of high interest rates? Let's buy those instead of lending to new companies. We'll make a fortune!

This old value over new is not new. During Reagan, art auctions for antiques went into record breaking levels. Bush as well. The housing bubble is the same thing. Don't invest in new things, invest in things that are valuable only if the rate of interest is zero. These things are rarely innovative.

The flip side is what happens when the economy is going incredibly? We have the same problem. I have $100B and I want to invest. Well, so do a lot of people. So should I invest in long term progress to build a greater nation, or should I invest in what I know is overvalued commodities that are rising 10X the rate of everything else? If you can get out at the right time, go for the bubble! If you don't, you lost your corner office to the guy that did. Oh and the multi-billion dollar bonus as well.

Finance is a strange beast that should not push the bounds of the market because it serves as a fundamental arm of government. Just like the Army should not try to make a profit (Shudder and think of that outcome), banks should be limited in what they can do to make a profit.

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