Saturday, February 6, 2010

Thoughts on Nobel Laureates Trace How the Economy Began to Fall Apart - Earl Malvar

I agree with Paul Samuelson’s belief that there is a need to return to financial moderation through regulation. Advocates of the Free Markets philosophy, I think, have a plausible point in saying that markets will ultimately regulate themselves, but human greed can sometimes get out of hand and lead to irresponsibility and unaccountability. Moreover, it is alarming how accelerated innovations in financial markets could become extremely destructive and almost likened to a speeding car crashing into a brick wall if left unchecked. Necessity paves the way to development and evolution and if it could be considered fairly applicable, Charles Darwin’s Theory of Evolution is true to applied finance as well. The weak financial products and tools do not survive, and those that become integrated and vital to the market and the economy flourish. Robert Merton had a good point on the need for risk-taking. It may be true that unbridled greed had a major part in the crisis, but in hindsight and barring malicious activities, market players engaged the situation based on the rules, limits and restraints that sculpted the functions and framework of the US economy. It was in accordance to what regulators, authorities and in fact all stakeholders thought fit and acceptable. It would only be natural for stakeholders big and small to operate and thrive on the given conditions. And though the trough was as deep as it got, I think it is how markets develop, mature and evolve. Prosperity will always have an antithesis to it, if not based on the fundamental laws of nature. In fact, if none of the mess occurred, all activities prior to the crisis may as well have continued on without any question. The eventual bursting of the real estate bubble and the flaw in the valuation of structured products, however, highlights how a system so critical to civilization can be sensitive and fragile to neglect. This was how home prices, on which so many mortgage-backed securities were valued on, were bloated; the market speculated that prices would always be on an uptrend and that there was real demand. Risk in itself, however, is an absolute reality in finance, in fact it is a natural part of life, and so in the pursuit of investment and wealth management, it is inevitable to encounter it in varying degrees. Derivatives reassign risk to those who can bear it, but risk on massive amounts of money can be destructive. Leverage in a functioning economy accelerates innovation and development, especially if the debt taken on is by a legitimate going concern – a business that may be involved in engineering, pharmaceuticals, health care and other critical institutions of society. In my opinion, leveraged positions in the field of finance, especially if tantamount to binary or two-way betting can sometimes distort the activity of risk-taking. A bank lending to a borrower in need of tangible goods/services to me is an acceptable function of the banking sector because the financial system is based on redistributing funds from those who can afford to lend it to those who are in need of it. Leveraging money on money, however, especially in speculative activities can be harmful if not kept under regulation.

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