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The slippery slope

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The slippery slope

Once upon a time I believed that the U.S. system of government was superior to ours in Canada. There was the potential for more serious and objective policy discussions in the various committees of Congress, and for more sophisticated policy analysis. However, I must admit that I no longer believe this to be the case. The U.S. system is entirely dysfunctional.

Almost non-stop campaigning and the continuous need to raise money have greatly increased the political influence of lobbyists and special interests. Politics has become vindictive and mean-spirited. And the absence of term limits has created lifers in Congress, many having passed their best before dates, and most beholden to one or more major contributors.

Paul Barrett, writing in the December 28 edition of Business Week, lamented that the U.S. did not “take advantage of the Wall Street crisis of 2008” to make “2009 the Year of Real Financial Reform.”

According to Barrett, “the Obama Administration offered half-measures. The financiers lobbied against even modest reforms, and a Congress drenched in Wall Street campaign cash has peppered proposed regulation with loopholes.”

I have commented before that the starting point for reform of the financial system should be Paul Volcker’s recommendation to restore Glass-Steagall and make banking boring, as it should be with deposit insurance.

I now suggest that Congress should take a closer look at how Wall Street makes much if its profits; namely, through trading. Whether the large financial institutions cross the line on insider trading when they engage in what they euphemistically call “proprietary trading” is a subject for others to debate. I believe that insider trading laws should be repealed.

However, a look at trading activities will lead to a number of interesting findings. For example, these trading activities have made financial asset markets much more volatile, increasing the costs of legitimate hedging and making longer-term planning more difficult and uncertain.

Oil prices were driven to unsustainable levels in 2008 by speculative trading, and they might be driven up again in 2010 by the same traders. Oil is too important for the global economy to allow traders to whipsaw prices.

Then there are credit derivatives. As far as I can tell, they served two purposes. One was to give traders another vehicle for betting against companies. Several of the beneficiaries of the AIG bail-out and the subsequent pay-outs to the buyers of the credit default swaps sold by AIG happened to be major Wall Street firms.

The second was to enable institutions, which were restricted from investing in lower grade debt, to invest in such debt by innovatively packaging together less than investment grade mortgages and convincing credit rating agencies to bless these securities with sufficiently high ratings.

The argument put forth by creators of these derivatives was that they enabled investors to buy credit insurance. This is an entirely bogus argument. Investors in various types of debt deliberately assume credit risks in order to earn higher returns. The interest rates paid by the issuers of debt reflect the market’s perception of the risks inherent in the debt. If investors want to avoid credit risks, treasury bills are always an option.

Investors in debt bought credit derivatives because tax laws and accounting principles allowed them to record a capital gain, and many belived the fairy tale presented to them by the salesmen of Wall Street that they were getting something (30 or more basis points) for nothing.

Credit derivatives should be banned altogether, or regulated as insurance, requiring resevres of 80% or more of their values. And a Tobin tax to make hyper-active trading less attractive is another needed reform.

But I do not hold hope for any real reform. To quote Paul Barrett again: “Genuine reform fizzled. We’ll regret it when the next crisis hits.”

The opinions expressed in this blog are personal and do not reflect the views of Global Brief or the Glendon School of Public and International Affairs.



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