The concept of an inherently perfect and stable financial market has been the leading ideology among economists for decades. This romanticized view of a magical self-policing market is pervasive. The Efficient Market Hypothesis and Adam Smith’s “Invisible Hand” concept promote the idea that stocks are priced perfectly and the market will best regulate itself. However, with the recent financial crisis, economists have been forced to reassess their views. Why did this perfect market crumble?The stability of the market is of paramount importance to America. The recent market devastation has led to the obliteration of retirement funds, increased foreclosures, and high unemployment. America’s global security depends on a powerful economy. A financial crisis of this magnitude cannot be allowed to occur again. This fall was in part due to inadequate regulation and blind faith in quantitative mathematical derivatives. The invisible hand that was supposed to guide the market became a sleight of hand that engaged in deceptive practices. Lack of proper financial regulation is an issue that must be addressed.
The view of a perfect market is backed with impressive looking mathematical equations. One of these equations is known as Value at Risk (VaR). This equation is used to measure risk and is viewed as a nearly perfect formula. However, this formula did not predict the Asian financial Crisis of 1997 or the Russian default on debt of 1998. Long-Term Capital Management crumbled and lost over 4 billion dollars during the Russian default due to faith in complex math. Mathematics should not be treated as absolute truth. This same math was used to rationalize corrupt practices that led to the American financial crisis.
Years of market deregulation by the government created an environment ripe for risk fraught capital ventures and unethical games. The repeal of the Glass-Steagall Act in 1999 removed the separation between investment and commercial banks. Investment banks used their depositors’ money from commercial banks to partake in risky trading. Investment banks had improper leverage. The actions of investment banks such as Bear Sterns and Lehman Brothers directly led to the financial crisis.
Recent regulatory provisions such as the Dodd-Frank Act and Sarbanes-Oxley Act are not perfect but begin to address fundamental problems present in a deregulated market. The selfish actions of a few elite bankers should not be allowed to completely wreck the lives of millions of hard working Americans. Economic busts permeate into the well-being of every industry and demographic. The elderly cannot afford the cost of living. Students cannot afford the high tuition costs required to attend a university. The success of the economy directly relates to the success of every individual. The solution to this problem is to pass proper regulation. Politicians need to look past self-interest and hyper-partisanship to properly protect the American public.
The economic damage caused by a market unfettered by proper regulation has been staggering. This is not to say that the government should become an all-powerful puppet master. There must be a proper balance between free market capitalism and appropriate regulation. Predatory lending and unethical practices should be monitored and corrected. The assumption that the market will run smoothly on its own is oversimplified.