Trying to Understand the Financial Crisis: And What To Do
I've been pretty silent on the recent decision for a Federal injection of cash into the financial system by purchasing old securities, mostly because I don't have a lot of understanding of the financial system as it currently stands. Â How can one really comment on whether or not a program will work if they don't know what the actual problem is? Â So, like most Americans, I have been silently watching and waiting, looking for (a) some reason to panic, and (b) some reason for hope. Â In the mean time, I have been looking for some good references on how the economy works. Â Then, on UEN's channel 9, I watched an economics professor hand the answer down. Â It was so brilliant in it's simplicity, and yet so scary to see it happen. Â All of a sudden, I understood how it worked, but that understanding scared me to death. Â Essentially, we have three levels of value in the financial markets. Â There is the (1) actual value, or the value of a product, commodity, or service in real terms, then the (2) projected value, or the value of that same product, commodity, or service in the foreseeable future given calculated growth (algebraic of course, so there is no estimated plateau in growth that naturally happens), and the (3) speculative value, or value of the product, commodity, or service in the unforeseeable future, or the long term, with continued geometric growth (i.e., a bubble). Â The Bank, at the base level, manages the actual value and the projected value. Â These are the base values that your home is sold to you, purchased through a loan (yes, the banks purchase it for you, you don't buy it until you pay off your loan), and so on. Â The bank purchases the property at the actual value at the time, based on the conditions of the market. Â Whether or not that actual value is realistic or not is part of another discussion. Â It then creates a projected value for the property based on the price you paid plus the interest that you will be paying on the property. Â In order to spread risk and better remain solvent in the financial sector, the bank now sells your loan out to financial investment banks, who pay the projected value. Â This assumes that you remain in your home and do not default on the loan. Â It also assumes that you do not pay off the loan early, because that shorts the investment of the projected interest that would be paid. Â Now that the investment banks have them, they need to make their money off of the deal, and so package the loans out with other securities, and sell them at the speculative value, or the value that such properties could make given geometric growth in the market, and so on.Â The speculative market now drives actual value, because those that create the original value (i.e., developers building houses) can drive the market up. Â Whether it's real demand or imagined speculative demand, prices go up, or better products are provided at the same price. Â Older products are devalued, and so on. Â Eventually, we get into a continuing spiral of constantly needing something new to replace the old. Â Houses, electronics, vehicles, toys. Â Everything is built upon these growing spirals, which eventually peak and then fall again as popularity wanes, or the next big thing comes along that takes consumer capital.Now, I could be wrong in how I understood the professor explain these three levels of financial value. Â If anyone out there has a better understanding, please feel free to post in the comments! Â I would like to have a firm grasp of the problem so that I know what the eventual solution would be, whether in the end it is to do nothing. Â So now banks are put under pressure to loan out money to pay for this growing consumer economy that has it's roots in a speculative financial environment, and as such they start taking larger and larger risks. Â I then heard about the culture of the traders on wall street in this interview done on NPRÂ (listen to it to get the real impact). Â It turns out that the culture of traders on wall street is focused around testosterone, where big risks and big money is a show of "manhood". Â Interestingly enough, women in the same position tended to be more rational in their speculation. Â So what does this all really mean in the end? Â Adam Smith was right. Â We will have a growth period, and a bust period in the economy. Â What's the best thing we can do in the mean time during this bust period? Â Watch our finances. Â Do we really need that plasma screen TV? Â Is HDTV really all that necessary? Â What about that trip to Europe? Â Should we be eating out so much? Â Is public transportation really that bad when compared to the expense of keeping your 10 mpg SUV running on the highway? Â It's time we as Americans started to think rationally. Â Stop worrying about what we can't control. Â If we have money in the markets and the markets are failing, there isn't a lot we can do. Â We can't even sue, because those that are "responsible" are either broke as well, or they probably have jumped out of a window by that point. Â Ultimately, we need to be realistic, understand that the world hasn't ended, and find more effective ways to invest capital. Â In the mean time, focus on those actions in the market that actually benefit people. Â I'm not talking about bailing out people that purchased homes they couldn't afford, but insuring larger sums of cash by the FDIC would be a good move. Â It provides solvency for the bank (increased capital that is protected by the FDIC), and increases confidence in the bank by savers. Â If a bank is solvent and has confidence, it can make prudent investments that will grow again. Â These investments will continue to grow and expand, and our economy will be back on it's feet. Â How quickly is still the Million Dollar question.