The depressing lessons of history, ignored
MARK CROSBY
May 5, 2010
If experience has taught us anything, it is the market cannot be left to regulate itself.
ONE might think that as an economist I would have great faith in markets and market systems. But in my view the most important part of my training as an economist was aimed at working out under what conditions markets fail - and what to do about them.
Most economists are in agreement that markets, if left alone, will not work very well. Natural monopolies and pollution problems require regulation or perhaps public provision to help the market along. Most economists, myself included, regard financial markets as subject to important forms of market failure. Banks have a bad history of failing, and creating significant problems for the wider economy when they do, and so regulation to strengthen that industry is an important part of an economy's legal infrastructure.
Even in the US this view of the importance of regulating finance was dominant after the Great Depression. During the Depression thousands of banks failed, prolonging and deepening the downturn. While most of the world economy was in recovery from the Great Depression in 1933, the number of bank failures in the US that year extended it there for several more years.
Subsequent changes to financial systems meant that banks and finance were very stable until the deregulation in many economies that began in the early 1980s. Much of this deregulation was a good thing, promoting more competition for example, but in some cases deregulation went too far. The first post-Depression failure in the US occurred shortly after financial market deregulation had begun, with widespread problems and failures in the savings and loan sector.
There have also been problems with particular financial products related to deregulation. In the mid-1980s, many banks in Australia offered their customers ''cheap'' Swiss franc loans. At a time when interest rates in Australia were well into double digits, farmers and many small-business customers were encouraged to borrow overseas at lower rates in francs.
Economic theory would suggest that higher interest rates in Australia tend to predict a weakening Australian dollar. In this case theory was right and a halving of the value of the Aussie in the space of a year resulted in a doubling of the principal outstanding for borrowers in $A terms. This could have bankrupted many, but legal cases against the banks resulted in the banks wearing large losses, rather than their customers.
The key issue in the lawsuits was the fact customers were not properly advised of the risks involved in taking out a foreign-currency loan.
Around this time, Bankers Trust in the US was being sued by four of its customers over losses related to derivatives products.
One was Proctor&Gamble, whose chairman at the time said: ''There is a notion that end-users of derivatives must be held accountable for what they buy. We agree completely, but only if the terms and risks are fully and accurately disclosed. The issue here is Bankers Trust's selling practices.'' In the end all four suits against Bankers Trust were settled out of court and it was forced to write off more than $100 million in derivatives payments owed to it.
The Swiss loan episode and other problems in the mortgage market in Australia in the early 1990s led to stronger regulation regarding protection of customers purchasing financial products - borrowers are required to acknowledge that they understand the terms of their mortgages. As a result, mortgages in Australia tend to be quite simple and Australian banks have not been in difficulties such as those now faced by Goldman Sachs due to the creation and promotion of overly complicated derivative products.
The US has pursued further deregulation since the 1980s. Alan Greenspan as chairman of the Federal Reserve was famous for arguing that the market would resolve potential problems. In a sense Greenspan was right, but the cost of the market solution has been enormous. The lack of regulation in the US mortgage market led to foreclosures and the housing meltdown.
The lack of customer protections has enabled financial firms to sell more and more complicated products to customers. The sophistication of these products has caught out not only customers, but even many sophisticated financial market players, such as the ratings agencies.
Goldman Sachs has claimed to a US Senate committee that it is only a ''market maker'', creating liquidity and prices for financial market products. The problem with that is that Goldman is the creator of the product - it is very easy to make money if an institution that is trusted creates a dodgy product to sell to unsuspecting customers and sets up a side scheme that makes money when the dodgy product fails. This is not market-making but making a market that is designed to fail.
The US in particular needs much more consumer-friendly legislation. Proposed changes to Australian regulations in the area of superannuation that more strongly protect consumers are to be encouraged. It is all very well to make a market, but some markets ought not to be made in the first place.
Mark Crosby is associate professor and associate dean, international, at the Melbourne Business School, University of Melbourne.
Source: The Age
http://www.smh.com.au/business/the-depressing-lessons-of-history-ignored-20100504-u7b7.html
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