The Financial Crisis Explained - Gambling With Other People's Money

Russ Roberts has made a career out of explaining difficult economic topics by relating them to ordinary life in a readable manner.  He explained why we should support free trade in The Choice and other economic concepts in several other novels that involve economic themes.

He's just issued a paper that explains the recent financial crisis very well.  You can download it here.

His critique is well balanced and very nuanced.  It covers all the bases to some degree, although it focuses most heavily on the problem he sees at the heart of the matter: government actions created a bailout expectation that led creditors to not act with their usual caution when it came to the housing market.  He partitions blame between the government and private actors who advocated the government's actions for personal gain.  I like that he takes a degree of personal responsibility, acknowledging that he had downplayed concerns about high leverage (ratio of debt to capital).  Most important, he rejects any easy, simplistic answers from the left (Wall Street Greed) or right (all due to Freddie and Fannie).

Here's just a very short "summary of the summary" to give you a taste:

In the United States we like to believe we are a capitalist society based on individual responsibility. But we are what we do. Not what we say we are. Not what we wish to be. But what we do. And what we do in the United States is make it easy to gamble with other people’s money—particularly borrowed money—by making sure that almost everybody who makes bad loans gets his money back anyway. The financial crisis of 2008 was a natural result of these perverse incentives. We must return to the natural incentives of profit and loss if we want to prevent future crises.

I don't agree with everything he says, this is probably one of the best pieces I've seen for those who aren't financial policy buffs but want to understand the connection between government activity and the economy a little bit better.

The Congressional Debate Over Derivatives

I recall Congress debating derivatives several years ago.  Listening to members talk about them was painful.  One member even discussed them as if Congress was discussing mathematical derivatives (such as that above) and asked why Congress thought it could regulate mathematics.  Needless to say, nothing was done at the time.

With the financial crisis and the role that derivatives well publicized (if not totally agreed upon), it appears Congress is now ready to tackle them.

Derivatives (as in the financial type - no the mathematical) are simply agreements for party A to pay party B some money if something else happens (interest rates go up, the price of wheat falls, the dollar rises against the ruble).  For many parties, such as farmers and manufactures, its a useful tool to "hedge" against a risk that party doesn't want to bear.  In current parlance, hedgers are known as "end users" and are generally thought to be ok sorts of folks.  The other guys are the "speculators" or those who create them to speculate rather than hedge any risk that derives from their business operations.  These are mainly Wall Street types.

The main questions being debated: to what extent must derivatives be standardized and traded through exchanges (with the exchange serving as a middleman) rather than customized and traded "over the counter" directly between two parties?  Next, to what extend should financial institutions need to segregate their derivatives trading from other financial activities?

These topics are way to complex to do justice to them in a blog, but I'll try to post some links to useful sources for those who want to learn more soon.