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Why we are not solving the financial crisisDonald Steward2/19/2009

The following is a example of how the Explainer was used to reveal the fundamental cause of the financial crisis and suggest how it could be solved at much less cost to the taxpayers than what is currently being done. I don’t understand why no one seems to understand this. It is probably because they don’t have access yet to the Explainer.

The output of the Explainer program showing the results of this analysis appears in Appendix II of my paper on this web site.

As with many explanations, the solution is oblivious prior to the analysis and obvious after. This is what I call taking the ‘li’ out of oblivious. Perhaps you can tell me why this reasoning might be wrong, or otherwise tell me why no one seems to be pursuing this approach. Below is my commentary. You are invited to comment.


For years the free market appeared to be performing flawlessly. It was greased with liquidity because borrowers and lenders, buyers and sellers, felt they could trust each other. But a fundamental principle for a free market to operate correctly is that the parties to financial transactions must each have the information needed to evaluate their risks.

When the foreclosures hit, it became obvious that the market had been operating with a fatal disease. Risks had been hidden. Risky loans were made to home buyers who wouldn’t be able to pay the higher rates when they were reset because they were told that house prices would increase indefinitely to cover their risk. Lenders bundled these loans, hiding their risks, and sold them to investors. The financial markets were selling sick cows to those who were unaware that the cows were sick.

When this was realized, trust and with it liquidity suddenly disappeared. No one would loan to anyone. The market crashed. People’s savings were wiped out and fear covered the land.

Everyone recognized there was a big problem and that ‘something’ momentous had to be done. What that ‘something’ was remained unclear. Investment bankers defined that something to their own advantage. The cry went out to use taxpayer’s money to bailout those very people who while making enormous profits had broken the system. Now they are making even more money, not from the operation of a free market, but from the taxpayers.

Too many people had a vested interest in playing this game and feared that if people were to understand the cause of the problem, they might persuade Congress to implement the focused regulations needed to assure that information was symmetric so the markets could work properly, ending their profitable game. The problem had many serious symptoms. But rather than turn off the hose that caused the problem, the focus has been on mopping up the mess evidenced by the symptoms. Apparently almost no consideration is currently being given to installing the regulations that would prevent the selling of sick cows and solve the problem.

Previously liquidity had made a lot of money available for the market to use. Now without that liquidity, the taxpayer is being forced to pour in a comparable amount of their tax money to make the system work again. Restoring liquidity would continuously pay for itself to produce an efficient market. But money that can only be replenished by people paying taxes is very inefficient and can soon come to an end.

The solution is not to reward those who in making excessive amounts of money broke the system and caused the problem. The solution is to invoke the targeted regulations that would provide the symmetric information needed to stop the sick cow game and restore trust, and with it restore liquidity.

Markets require a balance between the supply side and the demand side. Recently we have moved to the extreme on the supply side. Now to clean up this mess, we need to work from the demand side. The 350 billion dollars poured into the financial system could have provided three and a half million people facing foreclosure with $100,000 each to avoid foreclosure. The money would eventually reach and support the finance market. Supporting the demand side would be much more efficient.

If the source of the problem were recognized and some effort seen toward solving it, it might stabilize the market and save taxpayers hundreds of billions of dollars in toxic asset relief and stimulus financing.

A similar situation is occurring in the bailout of the U.S. auto companies. Rather than using the supply side approach by pumping money to the auto companies to build cars the auto companies insisted weren’t needed, it would be more effective to subsidize buyers to buy more efficient autos and crush their old autos. Perhaps we should crush the old, inefficient cars rather than do what GM did a decade ago, build electric cars then crush them.

 

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