mccleskey - when free markets fail; saving the market when it can't save itself (2010)

[...]... in The Wealth of Nations center on three issues, only one of which is really related directly to markets: the division of labor, the pursuit of self-interest, and free trade The markets he discusses, it should be remembered, were not specifically capital markets and certainly not capital markets as we understand them today The market mechanism he described was as much a reference to 18th-century markets. .. led to the Great Recession Some of the assets held at Bear Stearns, for instance, were linked to mortgage-backed securities or other difficult-to-price assets When confidence drops on securities like these, it can fall right off the map and take their market price with it No one wants to be holding the bomb when it goes off, and so the pressure to sell the securities turns into pressure to dump them and... risk, or to prevent unfair competition In other words, they are meant to correct the parts of the market that it can’t inherently correct itself Regulation aims to make realworld markets look more like the ideal free market model, and that is why it is illogical to argue that regulation has no place in a free market So the argument in favor of free markets is that market mechanisms work automatically... real-life markets work It is too often forgotten that markets came first, and market theory later arose to explain them Much of the recent debate seems to take the view that the models came first and markets should be constructed to reflect the (largely regulation -free) models to which the commentator subscribes In other words, it is all too easy to fall into the ideological trap of trying to make reality... time the firm retains the flexibility to deploy the money elsewhere as soon as the opportunity arises This is a far more efficient use of the money than leaving it uninvested On the other side of the transaction are firms that borrow money over a short duration to avoid long-term commitments that reduce their flexibility When they borrow in this way, they do so by pledging securities or other collateral they... where markets are too complex to absorb and process all of the relevant information The market collapsed in 2008 in spite of all of its efficiency The problem with invisible hands, then, is that they are invisible If we simply assume that the markets are invisibly regulating themselves, we abdicate our responsibility to confirm that they are in fact doing so That is the story of the last decade, and how the. .. describe what we now regard as markets and market behavior before The Wealth of Nations was published in 1776 But The Wealth of Nations gave the world an aha! moment when it described, in a mere thousand pages or so, the way that markets worked at that time And so, we rightly attribute the birth of the theory of free markets to Adam Smith and The Wealth of Nations Don’t try to read the book, unless you enjoy... one Finally, Smith was an academic writing a treatise on the theoretical principles under which markets operate Like other theories, it assumed away practical matters that complicate the actual operation of the theory (just as Newton’s laws of motion assume no friction) in order to illustrate the guiding principles of free markets Inefficiencies and imbalances distorted markets then, and they do now Some... can find itself falling from the top of the heap to the bottom of the pile with dizzying speed Still, in many cases the problem corrects itself eventually when an investor with a higher risk tolerance sees the value of the collateral as undervalued, or the higher interest rates extorted from the failing firm as a good investment The market creates a floor at which point investors come in, and the market. .. competitors, they fund each other This is one of the main reasons why they are so exposed to each other and why it is as important to see the connections in the financial system as it is to see the individual firms The fact that financial institutions fund each other is logical and perhaps inevitable They are not in the business of keeping money hanging around in vaults doing nothing, so they like to keep it . publisher. ISBN 97 8-0 -4 7 0-6 033 6-9 (hardback); ISBN 97 8-0 -4 7 0-6 495 4-1 (ebk); ISBN 97 8-0 -4 7 0-6 495 5-8 (ebk); ISBN 97 8-0 -4 7 0-6 495 6-5 (ebk) 1. Financial institutions–State supervision–United States. 2 16:28:32 Page 1 When Free Markets Fail E1FFIRS 06/16/2010 16:28:32 Page 2 E1FFIRS 06/16/2010 16:28:32 Page 3 When Free Markets Fail Saving the Market When It Can’t Save Itself SCOTT McCLESKEY John. generation. When Free Markets Fail: Saving the Market When It Can’t Save Itself outlines everything you need to know to stay abreast of these changes. Written by Scott McCleskey, a Managing Editor at