As the financial world turns

Standing in front of a large room at The University of Georgia, Professor Richard Timberlake conducted a doctoral seminar on monetary policy by posing questions to the class. Timberlake, a disciple of his dissertation chair from the University of Chicago, Nobel Laureate Milton Friedman, spoke glowingly of the decades prior to the creation of the Federal Reserve system and asked us what additional advantages to those he had enumerated would benefit the US if it simply abandoned the regulation of money altogether. I looked at the only other student in the class, who shrugged. I addressed our learned professor: “Dr. Timberlake, the class does not know.” He laughed, realising his method was more suitable to a full lecture hall and instructed us to meet in his office from then on.

One day during our seminar, he picked up the ringing phone and reminded his secretary that he was conducting a seminar in his office and was not to be disturbed. After a moment he said, “By all means, put the senator through.” After a few more moments of his listening to the caller he said he had a couple of doctoral candidates with him in a seminar who were discussing that very issue. Could he put him on the speaker phone? We were introduced to Senator Phil Graham, who had also earned his Ph.D. at Georgia, and was calling his old professor to discuss some finer points of policy. Senator Graham would later chair the powerful U.S. Senate Committee on Banking, Housing, and Urban Affairs and, more recently, co-chair the economic advisory committee to presidential candidate, John McCain. He still appears with McCain as his economic advisor, but he had to step down from his formal position after dismissing the economic slow-down as “a nation of whiners.”

As a student of financial economics in the US for most of the last thirty years, my zeal for unfettered markets waned in the 1980’s as “free market Reagan” bailed out the division management’s leveraged buyout of Harley Davidson from a mismanaged conglomerate, AMF. He intervened with tariffs of nearly 50 per cent on all imported motorcycles. This use of government to single out a company for protection, as the bailout of Chrysler in the decade before, proved successful. But deregulation of the financial markets under Reagan led to a costly savings and loan debacle. The outrageous predatory mortgage lending earlier this decade put us on notice that the markets were ready to fail again. I, as most others, had no idea that institutions around the world had so wholeheartedly—some would say foolishly—bought into the myth that rating agencies would protect credit-swap hedgers and speculators who protect mortgage-backed derivatives investors and speculators who were protected by mortgage pools underwritten by mortgage companies with sales forces with no more sophistication than door-to-door vendors pushing junk mortgages onto houses the owners could not afford and whose initial, qualifying interest rate was below the lowest rate paid by Wal-Mart.

Using highways as an analogy, the free-market faithful believed they should be privatised and paid for with tolls. No government speed limits would exist as dangerous driving would be self-regulated by the threat of civil damages when accidents occurred. In addition to excluding the poor from the rapid movement systems, the cars would be faster and bigger until only wealthy individuals and corporations would have vehicles that were safe on these, the fastest routes. The middle class (those with less than four million dollars, according to Phil Graham’s candidate) would eventually benefit indirectly by the freed-up time and money made by those who are worth more and who are financially justified in using this market-rationed resource via trickle-down economics. Those non-rich who would make it onto the turnpike would hopefully stay in the slow lane.

So is it unregulated speeds of the toll road that causes major crashes? Well, sort of. There was a time in the development of roads and automobiles when expensive cars that could achieve 50 miles per hour eventually caused more crashes than society would bear; but it was as much from the slowest vehicles sharing the same road as the fastest. A highway where everyone is moving precisely the same speed, even very fast, is safer than (as, e.g., in George Town) a street shared by cars, motorbikes, bicycles, and pedestrians at speeds varying from 2 to 30 miles per hour. Speeding may increase the hazard of a crash but increases in the variation of speeds also increases the risk of one.

Likewise, the increased efficiency in financial markets through the decades has unleashed vast wealth. However, those with the fastest (high yield/high risk) vehicles (securities) not only presented a hazard to their drivers (investors) but also increased the variations in the market until one crash lead to another. Even vehicles that were solid and cruising at safe speeds are piling up in the wreckage—the sell-off of fundamentally valuable equities in low-risk companies.

Perhaps even those in the fastest vehicles injured in the pile-up will see the value of regulations which will allow for increased efficiencies and yet govern to keep the variances within limits for robustness. But do not count on the die-hard extremists of laissez-faire capitalism to cry uncle (Sam). Anything that prevents the highest margins for the few in favor of a moderate margin for the many is at least wasteful, and, to many, a sin against the gospel of wealth. I say this because I learned from the same masters when this economic philosophy was at its zenith.

Milton Friedman (Nobel 1976) demonstrated in the last century that socialism stifled wealth for all. This century begins with Paul Krugman (Nobel 2008) demonstrating that so does a capitalist plutocracy. Perhaps we can draw from Darwin that we advance by avoiding extremes. Such are our growing pains.


An eye on the UCCI: Ginnie Gardiner, Ph.D.Associate Professor of Finance & Business Administration University College Cayman Islands