I wanted to make this thread to maybe start a discussion with the smart people on this forum. I know most traders are hardcore believers in capitalism and free markets, but I've come to believe this view to be flawed. We all like to think we see the big picture, that we're right and the sheeple don't know any better, but it's a bit more complicated. I've recently read "Other People's Money" by Noni Prims, released in around 2003. She is an (ex, presumably) Goldman Sachs managing director, so she knows her stuff. The book was a revelation. Everyone go read it. In one of the pages she predicted that Paulson would go back to Washington. It talks of course about the 2001 market crash and what caused it and she spends a lot of time on 3 industries, the banking industry, the energy industry and the telecom industry. Sure, we all know a lot of fraud took place, that there was an internet mania that caused billions in losses for everyone, but did you know a lot of it had to do with deregulation? Noni Prims repeats the pitfalls of deregulation on every page, granted, but the pieces all perfectly fall into place. For example, the telecom and energy industry used to be heavily regulated. Enron was a small pipeline company and Global Crossing didn't even exist before the deregulation. But after heavy lobbying(Ken Lay used his PhD in economics to argue for deregulation) the barriers were brought down. All of a sudden energy companies were buying up fiber optic cables! Small energy companies everywhere borrowed billions(blessed of course by the banks) to build capacity, and Enron built up its trading business. Enron by the end had 90% of its revenues come from trading. All it did was buy up capacity or energy then trade that energy for higher prices. Many states had their electricity bills multiply many fold, did deregulation suddenly make the whole system more efficient? Not even close. And of course a lot of these companies either went bankrupt taking away jobs and pensions or either survived with heavy debt which they then had to pass to consumers, increasing prices. And this brings us to banking of course. The book was written in 2003, and the author again prophetically (if anything it boosts Goldman's reputation) said that the new safeguards put in place were laughable. The problem at the core lies with the banks. You see, the banks back in 1998 had their business change with the Glass Stegall act repeal which lead to the consolidation in the industry. Deregulation is good right? Wrong, because simultaneously, the use of derivatives was being widespread. We all know that the toxic CDOs that caused this latest market collapse were created by banks, but who created the subprime loans? <i>Those very same banks</i> Who relaxed the loan standards? (and thus increased house prices) <i>those very same banks</i> The commercial side of the bank is able to make the loans, while the investment side is able to distribute them to investor. I don't think the blame is laid enough on the banks for the sub prime crisis. We blame Greenspan, maybe the government, maybe greed, but a large part really falls on the banks. Anyway. Most of the stuff up to now is just a revision for most. I still remember when Paulson proposed that we might need additional regulation, every person in here was heard cringing and going in slow-mo "No, don't kill the sacred cow!" Everyone thought it was nothing but a political move right? It probably was, just in a much different manner... Anyway, so why has the market failed? Let's analyze the assumption. The assumption is that having a free market will allow people to act in the most beneficial way for themselves, and therefore they would act in the most beneficial way for the economy. The assumption is that government is too slow and too stupid and should never be allowed to interfere with the market. Really, when it comes down to it, the needs of the individual and the needs of the society are aligned ONLY under free market capitalism. We believe in free market capitalism after all because it is most beneficial to society. Now let's look at <i>reality</i>. In our complex society, we're almost all subject to moral hazard. Moral hazard is the equivalent of the Greenspan put. If we succeed, we earn the rewards, if we fail then nothing bad happens to us. It is a very powerful force in our society, much more than a buzz word. Take for example trader Jerome Kerviel. He wasn't a bigshot, he was a regular employee. Yet in the complex environment he was part of, his short term objective(reach his bonus) were not aligned with the long term objective of his bank(steady increase in earning). The concept of moral hazard is EXTREMELY important, because the whole free market assumption lies on the individual managing risk the most efficiently. But Kerviel had no incentive to manage risk efficiently, and he therefore took as much risk as possible to reach his bonus. He is not a rogue trader, he is not a bad apple, expect such situations to continue. Let's get back to banking. Citigroup with trillions on its balance sheet cannot be allowed to fail, never. The wisest person on earth would never agree it would be good for society to let Citigroup fail. Bam, you've created moral hazard. Because of the Glass Stegall act repeal, banks are also able to get rid of bad loans they make, so Citygroup and other banks have absolutely no incentive to manage risk efficiently. They WILL create bubbles whether intently or by mistake as long as their short term goals (hit the quarterly numbers) are not aligned with the long term goals of society (stable, profitable bank making conservative smart loans etc) But you tell me, obviously the banks defrauded their customers, selling them crappy CDOs since the saying is "buyer beware" after all isn't it? Well yes and no, remember I said that moral hazard exists everywhere? What does Joe Blow care whether he buys toxic CDOs for his mutual fund that will go off in 3 years, Joe will be working at a hedge fund in 3 years from now! No one has any incentive to manage risk for the long term. Hell the shareholder doesn't even care about the long term. The whole assumption of the free market rests on the individual being able to manage risk more efficiently than some 3rd party(like the government). IT IS SIMPLY NOT TRUE. You see, 2001 was not the case of a few bad apples, Bush was lying to your face. It was the case of structural problems with the American economy that have not been solved. One of the most popular thread in the economics section is the thread on whether Obama will be good for the markets (and the economy). Obama has been heard a few times saying protectionist comments. No he is not retarded. I have not discovered the light bulb here, if anything the book made my ideas clearer. Many people know that it takes smart regulation, that some industries are better public, that others might need to be more free and should have little red tape. But these people dare not speak up unless the mass media, economists, and people with high IQ everywhere lash at them with a vengeance. This free market theory has become a religion. If it happens that Obama has a few progressive, enlightened economists on his staff, that we should let him be. No wonder politicians are forced to dumb down their dialogue, even people who fashion themselves as smart could end up being wrong! No I am not advocating to tax everyone to the hilt, I am not advocating to make every industry public, what I am advocating is critical thinking, not dogmatic statements. What can we do to fix the problem? Simple, the Glass Stegall act could be a beginning. Another beginning would be to make some of the loans illegal, to *gasp* selectively regulate the banking industry. Up here in Canada our banking industry is regulated and it works great.