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The Dangers of Financial Speculation | Curiosity is Dangerous
One of the most controversial areas of Economics is finance. What has played a huge role in this is the financial crisis of 2008, and the resulting ‘Credit Crunch’ that cost so many people their jobs, businesses and incomes. Consequently, there has been a resulting view of bankers as reckless speculators who destroyed the global economy.
But, can we live without finance? Surely, if we could do this, we’d have already eliminated these threats by now. Can you imagine a world without any more bailouts?
What exactly is finance?
In its simplest definition, it is a service for borrowers. When people want to borrow to buy a house, they go to a bank. The bank provides a service (a mortgage), to give borrowers the opportunity to buy a house.
A large amount of borrowing also comes from businesses and governments. These economic agents need access to credit to keep their services running. Without borrowing or lending, the modern-day economy would probably not function.
The financial sector also provides insurance against risk. Borrowers could easily end up in trouble without some sort of safety net.
One of these risks is called ‘exchange rate risk’. Take for example, the European company Airbus. Earnings are often paid in dollars. Meanwhile, expenses are paid in euros. So this makes it very difficult to manage business finances. Sudden fluctuations in the foreign exchange market can severely impact the company’s earnings. For example, if the euro were to appreciate against the dollar, that would mean the company’s expenses would increases relative to earnings.
Insurance can be a good safeguard against this sort of risk. It can give a company added confidence to continue trading amidst FX market speculation.
Financial speculation can also destabilise an economy. People’s ideas about what might happen in the future, can end up disabling an economy. One way this happens is by a process called ‘securitisation’. This is a financial practice that involves pooling different kinds of debt into one big pot. This pot is then chopped up into little pieces and sold off in chunks to third party investors.
Let’s return to our example of mortgages. Once the bank lends you the money you need, there are two options:
1. The bank keeps the loan on its books and waits for you to pay it back over 30 years
2. The bank increases its liquidity. It cashes in early and sells the mortgage loan to another bank
Is it morally wrong to trade loans? Actually, it might be considered essential if a bank wants to diversify its portfolio. The problem is that if a bank can offload its risks to other investors, then the bank itself doesn’t have to worry if people don’t pay their loans bank. The risk is with the investors who bought the securitised loans. This can lead to banks becoming less stringent when approving loan applications.
This is what happened in 2008. The sub-prime mortgage crisis in the USA was at the source of the problem. A sub-prime mortgage simply means a mortgage that has a high risk of default. These mortgages shouldn’t really exist. But the US banking system placed a big bet on the US housing market continuing to do well. As long as house prices went up, defaults didn’t really matter as the bank could repossess a house.
But what if everybody defaults at once? Then the banks’ liquidity dries up, and the bank has millions of houses to repossess and sell without a chance of selling them. This leads to even more loss of liquidity, which results in a credit crunch situation.
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