This article on Der Spiegel Online about the financial sector made good reading . The following is an adaptation of the full article.
Speculation has always existed in economic history, but never to such an extent as today. Over time, the [finance] industry was able to rid itself of overly obstructive regulations. In fact, financial supervision was virtually eliminated. In 2004 the European Union had threatened to limit the foreign transactions of major US investment banks if the United States did not tighten its own regulations. This prompted five investment bankers to travel to Washington to exert their influence on the SEC. They proposed that the SEC be given the power to take a closer look at their high-risk positions in the future, but only if, in return, the banks would be required to keep less of their own capital in reserve to offset the risks of their transactions. From then on, the banks were able to expand their business unchecked. The second part of the deal -- the SEC's supervision -- was pursued far less energetically.
The financial industry had managed to create a belief system which held that what's good for Wall Street is good for society as a whole. Between 1973 and 1985, before deregulation began, profits in the US financial sector made up no more than 16 percent of the total profits of all US companies. This industry's share of total profits increased to 30 percent in the 1990s, and in the last decade it even reached 41 percent. It was no surprise that the myth of efficient financial markets was accepted so uncritically.
Of all people, it was an academic specializing in literary studies who managed to most accurately analyze the insanity of the financial markets and the impotence of economists. With his short 2010 book "Das Gespenst des Kapitals" ("The Specter of Capital"), Joseph Vogl wrote a bestseller that attracted attention among economists. His theory is that crises are not some kind of occupational hazard in the financial system. Instead, Vogl argues, it is the system itself that inevitably leads to new crises.
Vogl was teaching at Princeton University when Lehman Brothers collapsed. He knew nothing about financial markets, and yet he was fascinated by the "confusing empiricism," which had so little to do with theory. According to economic theory, the invisible hand of the market always leads to equilibrium, as Adam Smith wrote in his classic 1776 work "The Wealth of Nations," which Vogl refers to as the "Bible of economists." The same theory is still taught in universities today. But the theory also tells us that today's excesses in the financial markets should never have occurred. This leads Vogl to conjecture that "by no means does the capitalist economy behave the way it's supposed to." While the theory tends to be based on the economics of a village market, completely different circumstances apply in the financial markets, where both goods and expectations are being traded, and where speculative transactions are used to hedge against other speculative transactions.
Vogl describes the principle as follows: "Someone who doesn't have a product, and neither expects to have it nor will have it, sells this product to someone who also neither expects nor wants to have it, and in reality does not receive it."
This type of market will always have a tendency toward excess -- in either direction.
Paul Woolley holds the same view, but from a different perspective. He is intimately familiar with the financial markets, after having made millions working in the London financial district. He spent four years with the deeply traditional Barings Bank. He later worked for the American fund manager GSO.
In Woolley's experience, the idea that financial markets are efficient is erroneous. "All players in the financial markets behave rationally from their own perspective, but the outcome of this process can be disastrous for mankind," he says. His goal is to prove how dangerous the financial markets are. "It's like a tumor that keeps growing," he says. According to Woolley, there is no justification for the fact that this industry brings in more than 40 percent of all US corporate profits and pays the highest salaries in good years, while in bad years it is bailed out by taxpayers.
Woolley has observed the same phenomenon again and again. "The herd runs behind a trend until a crash occurs." Society, he says, also pays a high price for this behavior. "The financial industry is doing a pretty good job of destroying society," says Woolley. Many of his former colleagues, he adds, have a guilty conscience because "they can't believe that the financial industry is still getting away with it." He feels that bankers have a strong incentive to design products to be as complex and non-transparent as possible. These products enable them to earn returns upwards of 25 percent, because customers simply do not understand the extent to which they are being had. Structured mortgage-backed securities, the risks of which even their creators no longer understood in the end, as well as credit default swaps, which allow investors to bet on the bankruptcies of entire countries, are only the best-known examples.
The more activity there is in the markets, the higher the fluctuations and the greater the potential profits. There is little that the traders at investment banks and hedge funds fear more than a boring market, one in which the economy is humming along nicely and the prices show little movement. The conditions that are reassuring to managers and employees in the real economy often lead to depression in the financial sector.
Whoever has the fastest connection to the market stands the best chance of taking advantage of a critical millisecond and thus reacting to a price signal ahead of the competition. The computers are far more efficient than any human trader, because they can process hundreds of pieces of information per second. At the same time, such programs can also amplify -- or even trigger -- a crash. On May 6, 2010, prices on Wall Street plunged by almost 10 percent within a few minutes. To this day, no one knows exactly what caused the so-called Flash Crash. Because this sort of thing happens with growing frequency, the US Securities and Exchange Commission (SEC) has imposed a waiting period on computers in emergency situations. If the price of a stock has dropped by 10 percent within five minutes, trading is temporarily halted, allowing the human players to consider whether there is in fact a real reason for the sharp decline. Computers have long set the tone in foreign currency trading. The currency markets are now too complex for humans to manage alone. "We realized that you couldn't really manage this with the human thought process, it was too difficult, there were too many variables," says New York hedge fund manager Taylor. Many of his roughly 60 employees are IT experts, mathematicians and engineers. They feed massive volumes of data into the computers, including figures on the gross domestic product of countries, interest rates, commodities prices and inflation rates. "The only thing the computers can't handle are political developments, that is why we have me as Chief Investment Officer," says Taylor, although he points out that the money ultimately follows the instructions that are spat out by the computers.
Following the near-collapse of the markets, then-German President Horst Köhler characterized the financial markets as a "monster." And there were plenty of good intentions when it came to taming this monster. "History cannot be allowed to repeat itself," US President Barack Obama promised after the Lehman bankruptcy, while French President Sarkozy spoke of a historic opportunity to create a new world. The United States and Europe did attempt to constrain the monster that was the financial market but because the industry is globally interconnected solo efforts by individual countries are pointless. Internationally coordinated solutions are difficult. As a result, the regulations remain nothing more than piecemeal. Politicians haven't done much more than push around a lot of paper. The financial industry, new regulations are often little more than a sportsmanlike challenge to search for new tricks with which to circumvent the rules. In their conflict with politicians and regulatory agencies, banks and hedge funds have a clear competitive advantage: They hire the brightest minds in the financial world and pay them millions. The public-sector regulators can hardly compete. The banks' lobbyists can exert their influence on this process to make sure that many of the new regulations are watered down. But the monster cannot be tamed with half-hearted reforms
The European Commission has developed a draft of new capital market rules, which includes 165 pages of guidelines and another 500 pages of regulations. Under the proposed rules, banks would be required to keep more capital resources in reserve to protect against risk, and they would only be allowed to borrow up to a certain ratio. These proposals make sense, but the financial industry is already two steps ahead. It has created a world in which the usual rules for exchanges and banks do not apply: the realm of the "shadow banks." For bankers, this is by no means a world of illegal or semi-legal institutions, despite what the term implies. Hedge funds and private equity firms are known as shadow banks. In the United States, shadow banks have already incurred debts of more than $16 trillion, as compared with $13 trillion among commercial banks. It is believed highly likely by some commentators that the next crisis will emanate from this largely unregulated realm of hedge funds. Britain isn't keen on keeping too close an eye on hedge funds, because the financial industry is one of the few remaining sectors in which the British are still competitive worldwide. This poses a huge risk for the financial market.
An effective financial market reform would have to treat shadow banks the same way all other banks are treated. This would mean completely banning so-called short selling, which is essentially betting on falling prices. It would also have to improve licensing requirements on new financial instruments and ban some that already exist, because they are designed solely for speculative purposes. It would also involve establishing a number of other rules that would make doing business significantly more difficult for banks, hedge funds and private equity firms. All of these measures would rein in the financial market and put its importance for the economy into perspective. Banks would have to concentrate once again on the role they played prior to the great deregulation of the financial market, namely to organize payment transactions, manage the investments of private customers and companies and finance their business deals with loans.
But that seems unlikely. There are too many contradictions and conflicts of interest between the countries involved and governments to allow such a massive change to occur.