Rational Irrationality in Wall Street

Economic man is coined in economics means a rational man. Rationality has a broad meaning: intellectuality, making meaningful judgement and etc. But following definition makes better sense "rationality is the triumph of the rational over the animal side of man." Current issues in Wall Street don't make sense in terms of rationality, well one feature of current issue makes sense:maximizing the corporate profit.

Recently, the Senators of the U.S have questioned the CEO and Fabirre Tau. In my opinion it's the set back of the capitalism which relies on economic man concept. The bank managers would be under pressure if they are lagging behind their peers, hence managers do all possible ways to boost the profit in short-term. Imagine there are only two banks in an economy, both of them oriented to long-term profitability. And, one of them tries to outperform its peer, and focuses on short-term profit by taking excessive risk and putting clients' money in risk. The second bank's shareholders makes pressure to management to increase the bank profitability, scared of loosing their job and career, the bank managers also takes risky positions. As we can see, simple game theory creates economic instability, both banks are involved in risky investments and collapse of market is predictable. The same case happened in the U.S, the banking holding were competing and trying to maximize their profit. Eventually the whole financial system was on brink of collapse, the Fed saved them, otherwise we were witness of chaos and collapsed the U.S economy.

If participants in an economy do make decisions based on game theory, they need to be controlled heavily, in order to avoid from next global financial crisis.

Greed is good, but not always

Recently, I've been reading the Warren Buffett's thoughts on investing. And, he said that "be greedy when others are fearful, and be fearful when others are greedy." In my opinion it's very true statement about investment. But, is it true about the banks?

The Security Exchange and Commission has launched investigation of fraud against the Goldman Sachs. The Goldman misled the investors/clients by not revealing all available information and risks of complex investment tool, Collateralized Debt Obligation(CDO). The bank has engineered with help of John Paulson, owner of John & Co Hedge Fund, and Mr.John had bet against collapse of CDO and took short position. Moreover, Mr.John payed USD15 million as fee to assemble the deal and find investors. Those investors were IKB, German institution, AIG and others. The IKB has lost USD150 million, the AIG was insurer of those CDOs. Nevertheless, the Goldman Sachs also lost $100 million due to inappropriate hedging. But, the Paulson & Co earned around USD 1 billion.

As we can see clients and partners of the bank had to carry a huge amount of losses. The bank didn't disclose the stake of the hedge fund, and the "clients" were sophisticated investors who relied on the bank.

What about other banks and institutions of the Wall Street? Are they operating ethically? These questions are subject to think and research.

Who is the Boss: Creditor or Debtor

The Chinese government is creditor of the U.S which had heavily invested into the U.S Treasury Debts,T-bills and others. Other creditors are Japan, Germany and other countries which have trade surplus or USD reserves. For example, the Chinese government holds roughly $800 million of T-bills, and the U.S federal government has almost $50 trillion in debt!!! I want to show the big picture clearly, 1 trillion is 1,000 billion. Yeah, it's a huge absolute amount. Investors, pundits and ordinary investors are worried about the debt of the U.S. Investors are taking worried to much on the value of USD and solvency of the U.S federal government. Does the U.S indebted?

I would say that $50 trillion debt is not a big amount relatively to assets of the U.S. Yeah, you did read it correctly a not a big amount. The U.S government also has balance sheet, like in corporations, its total assets equal to $111 trillion. If we calculate debt-to-equity ratio of the U.S is 83%, to corporation 70% is recommended.

Recently, I've read that people worried about the value of the USD, they were afraid that the Chinese government might dump it's T-bills and trigger collapse of the USD. It's a big myth, think a bit. If the Chinese dump their holdings, it would lead to over-supply of the T-bills, thus price would sink, where the Chinese would carry big losses, and the Federal Reserve of the U.S can easily manage this situation by buying long-term T-bonds. Here comes, that the Chinese are dependent on the U.S heavily and creditor is not the boss, but the U.S is the boss.

Trade Protectionism of the U.S

The Western economists propagandized the "Free Trade." The concept free trade implies to trades among countries without any quote and tariffs. The main argument was competitive advantage of each nation, for example father of modern economics Adam Smith had supported the free trade. And, the Western world urged developing countries, the World Trade Organization was established to oversee trade activities and deal with disputes, in 1998.
Well, no use of telling who history of world trade. My point from this article is to point out how the U.S is following wisdom "Do What I tell you, Don't do what I do."

The U.S government imposed 15% tariff on Chinese made tyres. The argument was unfair competitive advantage of Chinese manufacturers: undervalued renminbi(the Chinese currency. Moreover, the Japanese automakers had accepted "voluntary tariff" on the cars. The Indonesian manufacturers had payed the same amount with the French manufacturers tariff of roughly $8 billion. Moreover, the U.S Congress is trying to impose more tariffs on the Chinese products if China doesn't establish fair value of the renminbi.
We don't know what will happen, whether countries start "trade war" or not, but it's going to hurt each of us.
Hence, the U.S propaganda of free trade is manipulated, like author is changing the content of book as he likes.

Mr. Greenspan has changed his mind

Central Banks can influence to federal funds rate, overnight lending rate of depositary institutions to another depositary institutions, this would indirectly influence to lending rate of banks. The Federal Reserve of the U.S kept interest rate below 2.5% from 2001 to 2005, the results were as expected: borrowings of consumers, speculators and homeowners started growing at high pace. For example, households borrowed $4.4 trillion in total including mortgage and other types borrowings.

Cost of borrowing was too low, the U.S economy was flooded with cheap money, consumers were spending more than they earned. Corporation were taking any investment with return exceeding the cost of borrowing. On the other hand, speculators were investing in stock with return exceeding cost of money. The lower interest rates allowed refinancing of mortgage loans, the burst of housing bubble cause by excessive investing and irrational behavior have caused the bubble.

As governor of the Fed, Mr.Greenspan kept interest rate low and encouraged irrational behavior in stock markets and corporate management.

Mr. Greenspan is putting blame on regulators. I wanted to state his own words.

"Risks in financial markets, including derivatives markets, are being regulated by private parties," Greenspan said on Capitol Hill 1994. "There is nothing involved in federal regulation per se which makes it superior to market regulation." Nevertheless, Mr.Greenspan is playing another "song" now, I guess someone has to remind his point of view 15 years ago, which caused current global financial crisis.

Trade Imbalances and Trade Disequilibrium

When the U.S treasury secretary Tom Geithner accused the Chinese government for manipulating the yuan, the Chinese government responded negatively. Barack Obama imposed 15% tier tariff on Chinese products, free trade started struggling. The free trade proponent government started protectionism and trade war.

What are the impacts of the undervalued yuan on global economy? Generally, the Chinese economic growth heavily depends on exports, and it has several advantages: lower wages, manufacturers have easier access to loans, yuan is undervalued.

The greatest advantage of the Chinese companies is undervalued currency, meaning Chinese products are cheaper and more competitive in global markets. The government has the largest trade surplus with the U.S.

The Chinese government heavily invested in T-bills, because abroad earned foreign currency appreciates local currency once it brought to China and converted to yuan. The amount of the yuan would decrease and value would increase, this will eliminate competitive advantage of Chinese products overseas.

Currently, the Chinese government holds around $800 billion T-bills, and it's providing fund to the U.S government to finance it's deficit. If the U.S makes pressure to China to appreciate the yuan against dollar, what would be the consequences? Who is holding over whom, China or the U.S.

In this case, the U.S is winner. Assume, if China decides to dump its T-bills, it would depreciate the dollar and China will be the loser. In addition, the Federal Reserve of U.S can just buy them and hold, it would depreciate the dollar, again China will loose the game.