Tuesday, August 16, 2011

Putting a leash on Wall Street

Traditionally, the function of the financial sector has been to provide capital for business. Over the last few decades, however, it seems that Wall Street has become much more than that. As William D. Cohan argues in this Bloomberg article, Wall Street has now become a huge casino--with speculation, hedging, and arbitrage instead of craps, blackjack, and roulette--where the players get to make bets that have consequences for the US economy but not for themselves.

In the past, Wall Street transactions mostly consisted of actually buying and selling shares of companies. Recently, however, we have seen an explosion in derivatives, which allow investors to speculate on the price of shares or commodities without actually buying the shares or commodities themselves. Credit default swaps, a type of derivative, played a huge role in the credit crisis of 2008. Even Warren Buffett has called derivatives "financial weapons of mass destruction."

Even worse is the concept of "too big to fail." Currently, Wall Street bankers have no consequences for making risky investments--they are rewarded with huge bonuses if the bets pay off, and with bailouts if they don't. Some people think that the banks should simply be allowed to fail. The problem is, if letting the banks fail could lead to economic disaster, that's still an awful situation. People on Wall Street should not be able to take risks that could submarine the whole economy if they fail. Banks that are too big to fail are too big, period, and need to be broken up. Reinstating Glass-Steagall would be a good start.

What is the government doing to prevent another financial crisis like what happened in 2008? Predictably, nothing. Wall Street simply donates too much money to candidates of both parties. Oh, and most of Obama's economic team has ties to Goldman Sachs. The Dodd-Frank bill claims to be "finance reform," but it specified almost nothing and left the reforms up to a team of bureaucrats. The best way to guarantee that nothing good will be accomplished anytime soon is to leave something up to a team of bureaucrats.

Some libertarians have compared the current American economic situation to the events of Ayn Rand's Atlas Shrugged. In that comparison, Wall Street--along with Fannie Mae and Freddie Mac--would be the obvious choice for the role of Orren Boyle, the incompetent businessman who keeps himself afloat by using his connections to get constant favors from the government. Although Wall Street is not incompetent, they have been taking way too many risks that endanger the whole economy. Government has only been encouraging those risks, and in some cases (e.g. housing) mandating them. It's a classic case of crony capitalism.

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