NewWork Opinion
					Home

Dr. Raynor teaches finance at the State University of New York at Delhi, and is periodically a visiting professor at Universidad Catholica Santo Toribio De Mogrovejo in Peru. He has worked on a number of projects in other areas of Latin America, and was also a visiting professor in China. He is especially interested in international trade and labor issues, and has previous private sector experience in the banking industry.

With the global financial crisis dominating most areas of news shortly before the 2008 presidential election, the debate continues about the role of government in free markets. At the heart of the financial meltdown of course, is the crash of the housing market. This has caused many people to rethink the role of government. In general, is government intervention good or bad?

Government intervention can be good. We had success with the Chrysler bailout, the savings and loan (S&L) problem, and in some other areas. Responding to the current financial crisis is much more complex, however. Because of varying risk factors and other variables, nobody really knows the values of the mortgage portfolios held by many financial institutions.

The valuation concerns are largely because many of the mortgages--risky subprime and others--have been sold in the secondary market. Instead of a financial institution's holding and servicing mortgages like they used to, mortgages often are sold and repurchased in the secondary market. Risk is transferred and traded.

When the secondary market gets the mortgage-backed securities, they are frequently divided up by Wall Street firms. When they are put back together again, or repackaged, they are in a new form frequently referred to as financial derivatives.

The big problem with financial derivatives is that they are so complex in their repackaged form that even professionals in the industry really don't understand how they will react to market changes. For this reason they are incredibly volatile.

The best article that I have seen on financial derivatives was in Fortune magazine back in 1994, when these exotic securities were relatively new. The article was written by Carol J. Loomis who did an excellent job of trying to explain in layman terms what most would consider to be the unexplainable. Because this is so relevant to our current situation, CNN's Money.com just republished the article.

The opening paragraph reads: "To all generally well-informed business people, a few words of semicomfort about financial derivatives: First, if you don't really understand what these are, don't fret. Most of your colleagues, top brass included, are equally baffled. Second, if ten years from now--despite periodic booster shots from articles like this one--you still can't keep these things in focus, then cheer! That will mean derivatives have not been forcibly brought to your attention by bad, bad news, in which they make headlines as a villain, or even the villain, in some financial crisis that sweeps the world".

Ms. Loomis was right about everything except one small point: it didn't take 10 years for this villain to arrive and create the global financial crisis; it took 14 years. Her accuracy with everything else was uncanny.

For more than a decade, I have warned my finance students about financial derivatives. Not because I have a solid grasp of them, but to emphasize they should be avoided because they are so toxic. In fact, investor Warren Buffett calls them "financial weapons of mass destruction." Now that they have materialized in such an evasive way, he calls the current crisis our "Economic Pearl Harbor."

It should be noted that Mr. Buffett served as a consultant to members of Congress on the current bailout debate. Like most taxpayers, my confidence in government officials and regulators on this issue has been more than challenged. Mr. Buffett's participation in addressing the issue, though, is a welcome and much needed silver lining in the current crisis.

Derivatives are not just traded between financial institutions; companies in all sorts of industries hold them. One only needs to look at the fall of American International Group (AIG), the world's largest insurer employing more than 100,000 people, to see how dangerous they are. On September 28, 2008, the New York Times did an excellent analysis on how a group of people in a small department that handled derivative investments nearly wiped out AIG completely.

Many individuals obviously feel we were let down, and we were. We were warned that the day of reckoning would come, and regulators and other individuals from both parties were asleep at the switch. Yes, deregulation was a factor, but so was the mismanagement of government entities and public officials encouraging unrealistic levels of borrowing and leverage. Both parties were involved over an extended period of time in framing our economy that has brought us to this point.

The consequences of this crisis are significant, and escaping a deeper downturn may be difficult. The housing market is still a disaster, with many individuals locked into property they cannot afford. Much of this was brought to us via the subprime market and reckless lending. Foreclosures keep mounting, while many others are on the verge of losing their homes. Now the already burdened middle-class--what is left of it--will be put under additional stress.

Given all that has happened, how can we believe government intervention, when needed, will work in the future? The short answer is that we will have to, because we are going to need government even more for future prosperity. Not necessarily a larger government, but a government that is more nimble and functioning at a higher level.

Watching the bailout discussions unfold, I was struck by individuals saying the solution to this massive problem has to be quick and must work for the American people. While being "quick" and actually "working" are not necessarily mutually exclusive, they frequently don't go together. A quick fix may not work. Conversely, a solution that works may not be able to be formed quickly. In fact, conflicting short and long-term consequences are often the problem in many sectors of the economy.

If we had appropriate government intervention--note the emphasis on "appropriate," not "more"--our economy today might be much different. Thus, appropriate government intervention should emphasize sustainability. Balanced government intervention helps shape the marketplace so that private sector firms also can maintain sustainability initiatives. What should be the shape of future government? How can it encourage sustainability and be more proactive, as opposed to reactive?

Nobody understands sustainability better than New York Times columnist Thomas Friedman. Since his book The World Is Flat was published in 2005, it has been required reading in my International Business course. Mr. Friedman's new book, Hot, Flat, and Crowded, was just released and provides a path for getting our economy on track through energy technology (ET). If our current information technology (IT) resources are used to enhance ET, then we have the potential to change almost everything. "It will be like two giant rivers coming together--the IT revolution and the ET revolution. And when it happens--when it really happens--it will unlock more human potential, more innovation, more possibilities to lift people out of poverty in a sustainable way, than you can possibly imagine" (Friedman, page 240). Thus, leadership from our government is needed to provide incentives/disincentives to the private sector so that a new economy can emerge.

Friedman is careful to indicate that government intervention should only provide the structure, and then it should get out of the way. "If you only take one thing away from this book, please take this: We are not going to regulate our way out of the problems of the Energy-Climate Era. We can only innovate our way out, and the only way to do that is to mobilize the most effective and prolific system for transformational innovation and commercialization of new products ever created on the face of the earth--the U.S. market-place. There is only one thing bigger than Mother Nature and that is Father Profit, and we have not even begun to enlist him in this struggle" (Friedman, page 243-4).

Friedman's point here is that government intervention cannot be too aggressive. There must be enough to provide a structure--but just enough to do that--and then let the power of free market forces take over.

Nowhere does this type of public sector involvement have more potential than the auto industry. Earlier this year, I discussed how a directed stimulus initiative could enhance our economy and personal lives. With proper oversight and controls, a rescue plan for the auto industry could dramatically change the makeup of our entire economy as well as individual lives.

The just-announced 25 billion dollar loan guarantees for the auto industry, however, may have been rushed through. This was not the kind of bailout/rescue plan I had in mind.

What provisions are there in it to assure the auto industry will produce more energy-efficient vehicles? Will things really change, or are we just throwing money at the problem? Are the same people in charge, or will new leaders be in place to make sure benchmarks are reached? Are there new systems of incentives/disincentives in place to encourage industry progress? Government intervention in this case does not appear to be aggressive enough. In short, more (or less) government intervention is not as important as flexible and appropriate levels of government intervention.

While the auto industry may be the logical place to start, we also may need to rethink everything on a larger scale when it comes to ET. Fortunately, Friedman provides a path to follow with Hot, Flat, and Crowed. In a very real sense, we may not have a choice, given our current situation. We may need to throw the "Hail Mary pass" out of necessity. But then again, what do we have to lose. It may in fact be the biggest opportunity of our time. The big question is "Are we wise enough and can we get government leadership to take advantage of this opportunity?"

Friedman says: "But there is another reason, beyond the necessity of innovation, for a healthy society to want to reshape the energy market with taxes and regulations. It's called life and death, or stability and instability" (Friedman, page 259).

Balanced and appropriate government intervention is needed to provide the private sector with the structure it needs to make our future prosperity possible.

NOTES

Friedman, Thomas. (2008). Hot, Flat, and Crowded. Farrar, Straus, and Giroux. New York. ISBN: 13-978-0-374-16685-4.

Loomis, Carol, J. (March 7, 1994). "The Risk That Won't Go Away". Fortune magazine. Reprinted 9/25/08 online at CNNMoney.com.

Articles by Dr. Raynor:
Employee Value: An Accounting Paradox
Globalization and the Offshore Outsourcing of White-Collar Jobs
Outsourcing Jobs Off-Shore: Short and Long-Term Consequences
Global Outsourcing and the Disappearing Middle Class
Globalization, the U.S. Military and the Catholic Framework for Economic Life
Globalization and Outsourcing In a Flat but Unbalanced World
Higher Education Reform: Use Institutional Research to Enhance Quality and Control Costs
Ranking Colleges and Placing a Value on Degree Worth
The Good Business
Facing foreclosure? Remember That Your Lender REALLY Doesn't Want Your House
Why a Second Stimulus Plan Should Target the Auto Industry
Abuse of Credit Reports and Scores
Sustainability and Allocation of Resources
American Housing: The View from Peru
Government Intervention: How Much is Right In a Global Economy

Home

---

Copyright © 1995-2008 Gary Johnson Communications. All rights reserved. BraveNewWorkWorld, NewWork, NewWork News, Careers in the NewWork World, WITNE, and WITNE: Women in the New Economy are trademarks of Gary Johnson Communications.