Bad money: causes, effects, and economic implications

Economics - Book Summary

BOOK SUMMARY - BAD MONEY

In Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism, Kevin Phillips analyzes the current U.S. economic crisis and outlines the factors most responsible for its evolution over the last several decades. In chronological order, Phillips explains how the following issues and circumstances culminated in the recent collapse of the American economy: (1) the increasing influence of big business and special interest groups on legislative policy in Washington; (2) the increase U.S. dependence on OPEC to meet energy demands; (3) the increase in consumer debt; (4) government deregulation of banking, investment, and insurance; (5) government deregulation of the commodities and futures market; (6) the complexity of modern financial instruments and trading protocols throughout the financial investment sector; (7) the resulting destabilization of the home mortgage industry; and (8) rampant fraud on both sides of the consumer debt and home mortgage industry. Less directly, Phillips also implicates the Right-Wing Conservative orientation of the presidential administration of George W. Bush.

The U.S. Dependence on OPEC Oil:

Prior to the early 1970s, the U.S. dollar was partly dependent on gold. Since then, several agreements with Saudi Arabia and the Persian Gulf oil countries have resulted (in effect) in the dependence of the U.S. dollar on OPEC oil. In addition to indefinitely delaying the development of the alternative energy sources that we already knew would eventually be necessary, this relationship has also rendered the health of the U.S. economy to the price of oil and to retaliatory manipulation by Middle Eastern countries.

The Influence of Big Business and Special Interest Groups on Legislative Policy:

Beginning mainly with the presidential administration of Ronald Reagan in the 1980s, lobbyists representing big business and special interest groups became increasingly able to affect the outcome of government legislative policy agendas. During the administration of Bill Clinton in the 1990s, Wall Street financial services and investment firms succeeded in the passage of the Gramm-Leach-Bliley Financial Services Modernization Act (GLBA) of 1995, which allowed the merger of commercial and investment banks.

Increasing Consumer Debt:

Whereas previous generations of Americans largely restricted their reliance on consumer debt for major property investments (like their homes) and major purchases (like cars), during the last decades of the 20th century, Americans began relying on debt much more substantially and much less responsibly. A culture of debt-funded consumerism gradually evolved, characterized by the rampant use of credit at all levels of American society to live beyond one's financial means and that simultaneously reduced per capita savings tremendously.

Government Deregulation of Banking, Investment, and Insurance:

Just as the GLBA changed several fundamental rules that allowed commercial banks and investment firm mergers after 1995, in 2000, the Commodity Futures Modernization Act (CFMA) of 2000 deregulated the energy industry with respect to previous restrictions on the investment trading of energy futures. The first major consequence of this aspect of deregulation manifested itself in the 2001 bankruptcy of Enron and the more recent collapse of Lehman Brothers and, but for emergency government intervention in 2008, AIG.

The Lehman/AIG situations arose precisely because deregulation had allowed the commingling of banking, investment, and insurance, eventually giving rise to the collateralized debt obligations (CDO) and, ultimately, to the credit default swap (CDS) at the heart of the collapse of those financial institutions. Specifically, deregulation had allowed a roundabout way of "insuring" extremely risky leveraging, essentially, providing a means of generating huge profits from credit extension that exceeded assets by a ratio of 30-to-1.

The Complexity of Modern Financial Instruments and Trading Protocols: During the 1980s, computerization revolutionized the process of stock trading because of the tremendous increase in the speed (and therefore, the volume) of stock transactions on Wall Street as well as in the foreign stock markets in Britain and Japan, among others. Toward the end of the decade, Wall Street investment firms began hiring PhDs in mathematics and physics to create incredibly complex algorithms capable of modeling elements of the stock and futures markets. In most cases, the creators of these algorithms knew next to nothing about the financial industry, and the executives who employed them knew (literally) nothing about the mechanisms their firms had begun to rely on for their trading strategy. Destabilization of the Home Mortgage Industry:

In the early 1970s, stock analysts at Salomon Brothers, another Wall Street investment firm, developed a new kind of security based on home mortgages, called mortgage-backed securities. In principle, this allowed the conversion of illiquid (i.e. non- tradable) assets like the debt represented by home mortgages to be converted into a tradable commodity for profit. This new form of commercial transaction evolved into incredible levels of complexity after the widespread incorporation of mathematical algorithm-based trading and powerful computers within the investment banking and securities industry. By the end of the 20th century, billions of dollars were being traded on securities whose value lay in the combined debt owed by millions of individual homeowners. However, at roughly the same time, deregulation of the entire financial services sector fundamentally changed the age-old relationship that had always secured the home mortgage, since its inception. Specifically, prior to deregulation, banks, other lending institutions, and mortgage brokers had a vested interest in ensuring that they avoided extending credit to unqualified borrowers whose income, credit history, and available collateral indicated a low risk of default. Once deregulation allowed banks to sell off their mortgage debt to third parties instead of retaining them (and the risks associated with default) on their books, the incentive to ensure the creditworthiness of borrowers evaporated.

Consumer Debt and Home Mortgage Industry Fraud: