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Today we're going to focus on the providers of capital. Or we're going to focus on the role of financial markets and institutions, the productive role of financial markets and institutions. Now to start out that discussion, I want to ask you what kinds of financial markets and institutions do you know? Stock market. Stock market. What else? Futures. Futures. What type of futures? Commodities. Commodities. Commodities. Commodities. Commodities. Commodities. What else? What other types? Interest rate currencies and equity indices. And I'll include, and really all of these, you could also have options market and all of these we can call derivative markets. Derivative markets include futures, options, swaps, and a variety of other instruments. What other types of financial markets and institutions? Banks. Banks, yeah. Now what types of banks? Commercial and investment. Okay so let's take commercial and investment. Other financial institutions. Some of the big ones. Insurance companies. Insurance companies. What else? Also long term type. Pension funds. Pension funds. Okay. What are the big hot ones these days? Financial institutions. Mutual funds. Okay. Are we missing anything? SNLs. And mortgage companies. Financing companies. Well credit card is not a market in itself. Okay. One other big market that we're missing. Stocks. Bonds. I think we've got the major ones now. Okay. What is it that unifies all this? What is it that is in common with at least most of them? Not all of them. Yes. Well for the institutions, financial intermediation, maybe they act as intermediaries between sources and uses of savings. Okay. So the primary function, and I'd say that would be true of stocks and bond markets as well. The primary function of financial markets and institutions is to provide avenues for savings on the one hand and on the other hand to provide capital to producers. A bank as an financial intermediary takes in the savings of depositors and loans that money out to businesses. Now we'll get back to that dual role in a minute. Let's bake it up now. So look at the role in terms of saving. These institutions provide a return on savings. Now you can save money in the mattress. And in the days of gold you could actually maintain your purchasing power by putting the gold in the mattress. What financial markets and institutions do is they provide you a return on your savings. In that way they can expand the number of people who are sources of capital. Since they're expanding the number of capitalists. Anybody who has a saving account in the bank is now a source of capital for production. Labor itself can become capitalists by using their pension funds to invest in stocks, which they do today, by opening up savings accounts in the bank. And that their savings are now helping start businesses and helping expand businesses. So you expand the number, the quantity of capital available. The number of sources for capital. But the primary feature in terms of saving is that these institutions allow you to get a return on your investment. Now think if they didn't exist. If you didn't have a bank, or you didn't have a stock market, what would you have to do in order to get a return on your savings? Well you could loan it out to somebody who had a business, but you'd have to know that person. You'd have to put together a whole contract specific for that relationship. Or you could start your own business. But that's it. You could either invest it in your own business and get a return in terms of profit. Or you could loan it directly to an individual who you knew who was starting a business. Both very complex transactions. Starting your own business involves a complete change of career. Some of us don't want to own our own businesses. Some of us are not good at owning our own businesses. That would not be the most productive use of our time. So that's the one side of the equation. That's the saving side of the equation. Let's look at the side of providers of capital. What these institutions and market make possible for businesses is access to capital. And access to large amounts of capital for either starting up a business or expanding an existing business. It makes it possible for the businessman, for the manager, for the entrepreneur not to be a capitalist. It makes it possible to separate out those two functions. The banks, the stock market, the bond market, SNLs are the ones who provide the capital, the business and can concentrate on running the business. He can concentrate on, an entrepreneur can concentrate on starting up the business. The capital comes from a different source. Again, think about what would be involved in starting up a business or even expanding a business. If these institutions did not exist, if these markets did not exist, how would you start your own business? You would have to save for years, put the money away in the mattress for many years until you had enough to start a business. Now, what would be the size of these businesses that you could start based on your own ability to save? Very small. Very small. So, what they provide is a large pool, a source for large amounts of capital. By pooling all these, all our little bitty savings, I'll get pooled together. Now we're talking about millions or hundreds of millions and sometimes billions of dollars that these markets can provide. Of course, another use is for consumers, whether it's mortgage for a house. I'm going to get to that. I'll get to that in a minute. I wouldn't, but I'll get to that in a minute. So, the important point here is that without financial markets and institutions starting a business, expanding a business would become almost impossible. Now, businesses that are running that are profitable generate capital themselves. They generate through their retained earnings, through their own profits. But again, that is limited. They would have to save those retained earnings until it was large enough to build a new factory. Whereas what you can do today is you borrow the money, you issue bonds, which is like borrowing the money, build the factory and then future profits pay it off. Also remember that ultimately the source of our savings comes from our ability to work for relatively, a lot of us, to work for large businesses. So we assume that they already exist even to generate our own personal savings. Most of the capital that exists out there is capital that's been created by through the profits of businesses, either through the savings of those businesses, they're taking the return earning and investing or returning it to shareholders in the form of dividends or paying back bondholders. So these big business generate big profits and that is the source of a lot of the capital that is available out there. Manual labor does not generate huge amounts of profits. Not enough that in a lifetime you could open any significant size business. Okay. What else do these financial markets and institutions do? Now one of the things they do is they provide capital for consumption or provide money for consumption. For example, if you want to buy a house, if these didn't exist, you would have to save every month, put money aside and when you had, in California when you had the $300,000 needed to buy a little house, you could buy it. Now you'd probably be 50 or 60 before you could do that. What the existence of these markets allows is it allows you to buy the house now and pay it off. So maybe by the time you're 60 you've paid off the house but you've lived in it all this time. So it allows for what we call in finance consumption smoothing. I don't have to wait in order to benefit materially from the work I'm doing and the work I expect to do in the future. I don't have to wait and accumulate my savings and then make the purchases. I can make the purchases today and then pay them off over time. So I smooth out my standard of living. In a sense by buying a house I'm living beyond my means. I don't have $300,000 to buy a house but I can use the salary that I will get 10 years from now in order to buy this house then it becomes more affordable and that's what you do when you take out a mortgage. Same thing when you buy a car unless you can pay, most of us can't pay cash today for a car. So it's saying we'll use some of our earnings three years down the road in order to pay for it. It is these markets that make that possible. Now there is a fundamental difference between consumption and production and I'm not going to get into that a lot because that's more a topic for Dr. Beekner more an economics topic than a finance topic but consumption is an end product. You buy the car for the car you use it, the benefit you get is from using it. Versus an investment in building a car where the expectation is that from that car you will generate profit. So you're actually going to get a return on the money that you invested in the car. When you buy it for yourself you're not getting a monetary return for that investment. So I would separate consumption and production in that way. When you invest in production you expect a monetary return on your investment. When you consume you do not. That is the end result. That is what you want. You want the consumption. You want the benefit that that consumption. Provides. Okay. What else do these financial markets and institutions give us? What about risk? These institutions allow us to control risk. They allow us to control risk in various ways give you three different ways in which this can be done. Well I'll get to that. Us can be either the savers, the investors or the producers. So it allows both sides to control for risk. So let's start with the savers. We would all like to get a return on our money but how many of us is willing to you know take the thousand dollars that we own and lend it to a biotech company that's just starting up. That's pretty risky for all the money in the world that we have. So what can we do? Well what banks for example provide us with the ability is to open up a savings account. Well we are fairly guaranteed a certain return over five, ten years and then the bank turns around pools our investment, our savings with other people's savings and lends it out to the biotech company. What risk are we exposed to as savers? Okay so we have to worry about the bank going into insolvency. That is a much more reasonable risk for us to take on than worrying about the biotech industry. Something that we can much more easily monitor. Now in the world we live in today where the government provides us deposit insurance. You don't know what deposit insurance is? Posit insurance if the bank fails we're guaranteed our funds back at least up to a hundred thousand dollars and for all intents and purposes if you invest in it if your savings and a big bank however much you you've put away is guaranteed by the government. We don't even worry about the banks default. Most people and I think everybody just puts their money in a saving account and it's going to be there because the government has guaranteed it. As long as you don't assume the US government is going to default on its debt you're guaranteed to get your money back. So we don't have to worry about the risk that the bank takes on ultimately. All we have to worry about is the riskiness of the institution of the mutual fund of the insurance company of the pension fund of the bank and some of those are guaranteed by the government and in that way we are controlling the level of risk that we take on while still benefiting from the investment the bank makes. So how does the bank make money? It promises to pay us four percent on a five-year savings account then it turns around to biotech companies you want to loan for a million dollars from us you pay us ten percent and the six percent difference minus the expenses of the bank that's the profit. A mutual fund works a little differently. A mutual fund takes in our money it doesn't guarantee us a return but it says whatever we get an upper four year you get minus a percent that we take as fees. In both cases for example in a mutual fund we're investing in the market in the stock market yet we're taking on relatively little risk and this brings me to the second point which is the ability of a savers to diversify. Does everybody know what diversification is? It's when you buy a little bit of a lot of different things and then if something succeed if something's failed and probably other things have succeeded and on average over time you're probably doing okay. It's a way of reducing risk without giving up a lot of return a lot of benefits. So stock markets, mutual funds allow us to diversify even insurance companies. We can now buy into many many different ventures. Many many different industrial ventures. We can buy into banking. We can buy into all kinds of companies without being very rich because we can buy little tiny units of them. We can buy ten shares of IBM. Without a stock market that would be impossible. We would have to buy big chunks. We would have to be partners with the other people investing in IBM. So we can diversify across markets and across industries and it is markets that allow us to do this. Now that's on the savers perspective. So all we gain is A, these intermediaries and B, the ability to diversify. What controls risk from the side of the producers? What is it in these markets that allows producers to control their risks? One of the derivatives can help producer control some of the costs of production. Okay. So some of the cost of production and what else? Some of the financial risks that take take on. So these markets or we've called derivative markets allow producers to control their risks and let's divide this into two types of risk. One is financial risk. It is the risk involved in interest rates changing. Currencies fluctuating. Say you are exporting to Germany. Deutsche Mark can be up one day, can be down another day and that fluctuations can be fairly large. If you follow these things the dollar-yen relationship has changed dramatically over the last year and a half. It's gone down and then up very dramatically up to 30% changes. Now if you're an exporter or an importer you could be losing a lot of money. What these markets allow you to do is hedge that risk, protect yourself against that risk. Basically you lock in a price for the currency. So you know that six months from now when I need it this is the price I'm going to pay for Deutsche Mark. Or you could, I mean there are other ways of combining these type of derivative securities in a way that it doesn't matter which direction Deutsche Mark or yen or whatever go I will make a constant profit on this transaction. The same holds for interest rates. Financial institutions and a lot of other businesses are sensitive to changes in interest rates. Now through the use of these instruments they can control that risk. They can get a handle on that risk. What about commodities market? What kind of risk does that allow? Business is to control. Inputs. So metals for example or if you're a baker then the price of wheat. And now what risk for example agricultural commodities? What is the risk involved there? Price and what is the cause of the price? What's going to be the uncertainty? What generates the uncertainty? Supply which is generated by weather. The big unknown factor in agriculture and why these are probably these are the first futures markets that ever came into being is weather. We don't know it's going to be a rainy year it's going to be a dry year so we don't know the supply therefore we don't know the price and these markets allow us to guarantee a price. Lock in a price into the future so we can control the risk associated with weather. Or the risk associated with lower production of silver for example than we expected because of political unrest in South America or whatever. So we can control not only the financial risks using these markets but we can also control the risk associated with the resources that we need in order to produce. Any questions on risk? So we see how both from the savers perspective and from the producers perspective these markets allow us to reduce and control the risk that we take on. Okay what else the financial markets institutions do? What else do they what are the benefits that we get from them? What else to the providing? For example what is the price of a stock or the movement in a price of the stock? Does that provide us with anything valuable? Well hopefully all these activities are motivated by profit that's what makes it work yeah. It prides information information used to make future investment decisions. Exactly what these markets also provide us is information. Information for example on which industries are doing well and which industries are doing poorly. Stock price of companies of industries that are doing well that the markets evaluate as doing well would increase. Host buggy industry at the end of the 19th century is going to go down. Now let's say you're a supplier of leather to the host buggy industry and you're about to sign your contract with the host buggy manufacturer. It's a five-year contract and you notice that the stock of host buggy manufacturers is plummeting. What do you do? Does that give you anything of value in terms of decisions, in terms of negotiating with them, maybe changing what you're producing yourself so that it'll fit a different industry? What does it tell you that the price is going up? What kind of information is that providing? It would tell you that the industry as a whole is in trouble and that you might not want to put all your eggs in one basket and simply rely on a long-term contract. Some of the firms you have the contract with might go into bankruptcy and you'll be in hot water so you might want to diversify your customers. Yes, it's telling you that the market thinks, financial markets think that this industry is in decline, that there's something fundamentally wrong with the industry. Now it doesn't tell you what's wrong with it. It just tells you that it's wrong with it and it tells you, keep an eye out, let's maybe investigate this. Oh, there's a car market being developed and it happens that the stock of that market are going through the roof. So maybe I should start thinking about creating leather products for the car market. Or maybe I should not sign a five-year deal with these guys, just a one-year deal because they might go bankrupt. The stock market seems to think so. Those are smart people driven by the profit motive and they're selling. So you can see how industries you can not only in terms of investment but in terms of actual production decisions are made by stock prices, bond prices, by the information that is gleaned from prices of financial instruments. Stop by any of the 133 Los Angeles area O'Reilly Auto Parts stores where you'll find everyday low prices on the parts you need to keep your vehicle at its best. Our guaranteed low prices ensure you're always getting our best deal. In fact, we'll match any auto parts stores price on any like item. O'Reilly Auto Parts, better parts, better prices every day. Information on the managers of those companies, which is probably the hardest to get in the absence of this data. Yes, so it gives you is this company managed well or is it managed poorly? Let's say it's not the horse buggy industry. Let's say it's the car manufacturers and you know the three manufacturers. Let's say Chrysler and Ford stock are going up and GM stock is going down. Well, it makes you say well what is what's going on? Because they've all got about the same assets. They've got similar thing. You know, it wants further investigation. Maybe their management is no good. Maybe I can't trust them. So it gives you a lot of information not only in the industry but also firm specific. The quality of the management, maybe quality of R&D, the quality of things that are very difficult to observe from outside but which financial markets specialize in getting information on. These people, the people who trade in stocks and bonds are people who go into the companies and talk to the CEOs and go look at the lab and talk to the engineers. They are experts at this, at valuing these companies. And if they think the company's value is less than its current price then they will start selling which will drive the price down. Or if they think it's worth more they will start buying. You can decide to study some subjects because you think certain industries like the computer industry are going. Yeah, I mean you can't just use this information but this information provides you with a clue as to direction as to what the market expects future directions to be. In addition it provides important information regarding investments. You're an entrepreneur and you've got an idea for a brand new type of buggy wood. Post buggy, right? But stocks are just plummeting. Is this a good time to answer the industry? Oh you see stocks have just gone down 20% this year. Maybe there's a reason for that. Maybe I should look again at my idea. So it provides you with information regarding investments. Entrepreneurial investment but also investments in terms of your portfolio. So do I want to have 20% of my portfolio in this declining industry or should I try and look at something else? So information is important. What else? Another, some of the smaller roles. Financial institutions and markets also provide monitoring. One of the things they specialize is in monitoring the performance of companies and this relates to the point of are the managers good or bad? When a bank issues a loan it doesn't issue the loan and walks away. Many times it will send people to the company. They will check the books. They will sometimes sit in on if the company is in trouble they might even sit in on managerial meetings and provide advice and recommend certain course of action in order to improve the company. Actually another entity you might put up there are rating agencies which do that as their sole output. Yes so I'm not sure we would call the financial institutions but they're definitely involved in providing information, financial information. But if you think back to the 19th century the early 20th century people like JP Morgan bought large stakes of equity in companies actually sat on the board of directors and helped those companies with strategic decisions. Michael Milkin was frequently consulted by businesses on what he thinks in which direction they should grow, what kind of mergers he thinks they should take on even right now. I don't know if you know this but he is his parole was supposed to have ended about a year about six months ago and because he served as a consultant for Ted Turner on this big Warner Turner deal his parole is being now extended because the SEC is still investigating him. Did he violate his agreement with the court not to be involved in financial transactions anymore? So even today Michael Milkin is serving as a consultant to some of these companies and providing them with important information and knowledge and how to set up deals and not just financial deals, business deals. A lot of bankers at least historically were very very knowledgeable about business. So it serves monitoring and consulting purpose. Investment bankers specialize in this. They have M&A departments, they have consulting departments, they'll bring in their people, they'll give you real advice about how to run your business and they have an incentive to do this because they're usually invested in you. They have a strong incentive to make sure that you do the job right because that's where they're going to make their future profits. Okay, of all of those information, the monitoring, the risk and so on, the primary productive role. Now all of these are productive, all of these increase profits. The primary productive role of financial markets and institutions is to allow the efficient conversion of savings into capital in the hands of the producers. So the primary role is the conversion of savings into capital in the hands of producers and they do this by encouraging savings and how do they encourage savings through promised return, giving you a return and they compete on that. Banks will offer you different interest rates and they would compete even more if they weren't regulated. Stock market, the expected return is different than it is in a savings account but then the risk is different. Mutual funds compete against each other so the pension funds and insurance companies. What they are trying to attract is savings from you. They're trying to get you to save. Again without these people would save less because there would be less incentive to save, there would be less return. The freer these are, the more people will save. The freer they are to compete, the more people will save because the more incentive they would provide them to save, the financial markets and institutions. Then once the financial intermediary, the bank or other financial institutions get those savings they invest them. They allocate the capital available to them. They promote the efficiency of investment. What is it that promotes the efficiency of investment? The profit motive. The fact that they want to make as much money as they can. Given a certain risk level. You know some things are safer than others and you expect a higher return from those investments that are more risky. So if you buy stock in a biotech company you're expecting to get more out of that investment than if you buy the stock of a utility company which is fairly stable. Very low risk. Who used to be. That's right. By doing this, by acting to encourage saving and allocating capital, they are raising the productivity of labor as we saw last time and as a consequence raising the general standard of living. Now what would the world look like? What would the world look like without these institutions? What would happen if we didn't have financial markets and institutions? As I said before, every business, every new venture would have to rely on the owner's own savings for the foreinvesting. On what? On family, maybe friends, maybe venture capital. Now in this type of investment goes on. Steve Jobs, you know to buy the little components to build his first personal computer, borrowed money from family and friends. But once he had the computer and now wanted to make it into a company into a business, he went to some venture capitalists, some people who have money who are looking to invest it in new ventures and got an investment from them. Then he started out and built a small company. But you know to make it a big company, what did he need to do? To issue stocks and get to a lot of people to get to a very large pool of capital, to a very large pool of money. Without the existence of these markets, that pool of money would not be available. Again, the only way to make money on savings, the only way to get a return on saving would be to invest it directly. Either be the venture capitalist or be Steve Jobs investing your own money. Now what are the consequences? Now we have these markets. We have these markets today. And we don't live in a completely free market, right? We live in a mixed economy. So what are the consequences of having these markets and institutions but having them regulated? Having the ability to function constraint. Now I think probably the biggest problem, the biggest cost is the misallocation of capital that results. Capital going not to its most productive use. Not to where you can make the most profit. But to less productive uses. I'm going to get, I'm going to get to some of them. There's no way we could cover even a fraction of them. But I'll specify a few concretes so you get the idea. And the concrete I want to use and we'll do this briefly because it can become pretty complex. There's the SNL industry. Look at the SNL industry in the late 1970s, early 1980s. The SNL is the saving and loans industry. It's like banks. Saving and loans industry was created in the 1930s. It is separate from banks. It was regulated separately from banks. And saving and loans could do two things and really two things only. They could take in saving accounts. They were not allowed to take in checking accounts. They could take in saving accounts. And they could issue mortgages. And that's it. Now for many years this was fine. Till what? Inflation and competition for savers have other alternatives and they began to move on the other side. Well, let's focus on inflation. You're right. But let's just focus on inflation. Come the middle to late 1970s. Interest rates are what? No, late 70s. 13, 14 percent, right? Now, what generates the profits? What generates the income for an SNL? The money paid on mortgages. What were the mortgages that the SNLs were holding in the 1970s? When were they issued? These are 30 year fixed rate mortgages. They were issued in the 50s and 60s. At what kind of interest rates? Seven was high. There were mortgages at 5 percent. So the SNL is getting in 5 percent. What does it have to pay to its depositors? Something at least to compensate them for. Inflation now it happens that as an additional complication to the scenario that they weren't allowed, there was a ceiling on how much they could pay depositors. The Fed said, and this is true for banks as well in the 70s, this is why they gave away toasters and microwaves and stuff like that if you remember in order to try and get around this. But the Fed said you can't pay more than X on your saving accounts. And X was often below inflation. So if they got people to deposit money in their saving accounts, they had to pay them more than they were getting on the mortgages. They said there's a clean loss right there. You're getting 5 percent, you have to pay 10 percent. You've lost 5 percent right on the most basic transaction. In addition, people were taking money out of their SNL because they were saying I don't want to lose money here. I don't want to keep my money and get 10 percent when I can put it in a money market account and earn 15 percent. So SNLs were losing money or money was leaving that plus they were losing money on what they were doing. And this happened throughout the 70s, not the 80s. So the SNLs by 1979 won the bank of bankruptcy. They went deep trouble because they were losing so much money as a direct consequence of inflation. Is your check engine light on? Don't ignore it. Stop by O'Reilly Auto Parts today and let our professional parts people scan your vehicle for free. We'll retrieve the codes, discuss possible solutions and even help you find a professional technician if needed. Visit O'Reilly Auto Parts today for our free check engine light help. O'Reilly Auto Parts, better parts, better prices every day. O'Reilly Auto Parts. Now there's one other feature that is important to understanding the SNL crisis which is also common in banks and that is deposit insurance. What does deposit insurance say? It says that we as depositors don't have to worry about the solvency of our bank. We don't have to worry about how risky they are. Whatever they do, the government is going to come and bail us out. In 1980, SNLs were allowed to invest in anything that they wanted. They didn't have to just invest in mortgages anymore. Deposit insurance was raised to $100,000, so we were guaranteed to get back our money as long as we had less than $100,000. And this cap on the amount they could pay savings was eliminated over time, gradually, but it was eliminated. I remember in the late 80s, I remember that in the newspaper, they used to have a little section where they used to give you the different rates that SNLs were offering on CDs. And they were offering 15%, 16% on a short-term CD because they were taking in money. Now, why were people sending it? Because it was obvious that these SNLs were doing really, really poorly. Why would you still send money to an SNL that's doing really, really poorly? Because you're insured. Because you're insured. You don't care. You just want to 15%, 16%, which you'll get whether they succeed or they fail. What were the SNLs doing with all this money coming in? Making risky loans. Making very, very risky loans. Because the only way that they could get out of the mess that they were forced into throughout the 70s was to start making huge profits. Where can you make huge profits? Well, if you take a risk and it pays off, you make a huge profit. It's like a lottery. You put in a little bit of money. 99.9% you won't make anything. But there's that .1% that you'll make a killing. And what the SNLs in the early 80s, mid-80s needed was a killing. They needed to make a lot of money quickly because of what regulation had forced them to do up to that point. So where were they putting all their investment? What kind of investments were they making? Real estate. What kind of real estate? Land. Commercial real estate. Development. Texas was, there were so many high rises in Texas, they were empty. It was tragic. You drive through Austin or Dallas or Houston and you see office building after office building. Beautifully made. Everything new inside and there's not a soul inside the building. And we're talking about hundreds of thousands of square feet of office space. It was amazing. What else were they doing? Office buildings was one. What else were they investing in? What was hot in the early 80s? Shopping walls. Put that under commercial real estate. Something not related to commercial real estate. It was very hot in the early 80s. Oil exploration. Oil exploration. That's right. Because of the 79, you remember the 79, there was supposedly an oil crisis. There were lines outside the gas stations. Oil exploration became a big topic and it was great. It was just like a lottery. You go, you dig wells. If you hit oil, you make a bundle. If you don't hit oil, you lose everything. SNLs were pouring money into oil exploration. SNLs in general were looking for risky investments that could get them high returns. And they poured billions and billions and billions of dollars into these investments. And it was like a wave. It started in Texas and then it went to California and then it went to the northeast. They started failing in ways. Now, what happened was, of course, you take on very risky investments. Some pay off, very, very few. Most fail. So most of the SNLs failed. A few, the ones that survived are the ones that got lucky, for the most part. The ones where they took on the very risky investment, they hit oil. Texas SNLs were completely devastated. There were very few that survived the 1980s. So what happened? Because of all these regulations, from the original regulations that limited SNLs to financing mortgages and not being able to pay what they wanted on savings, to deposit insurance, what was created was an inefficient market and an unbelievable misallocation of capital. Think of all those billions of dollars that went into useless oil exploration, useless construction of office buildings, shopping malls and so on. Think of what it could have done if it had gone to Silicon Valley. Think of the new products we would have. Or think of what if somebody decided to start a new auto plant to compete with the big three using that money. Think of the new products or the cheaper products we would have got. The more efficient products we would have got. Yeah. SNL is the biggest or the bigger problem or the bad thing that happened is that they used taxpayers money. So not only was capital misallocated but basically another quarter of a trillion of taxpayer money was wasted down the drain. Well, the cost of the SNL crisis in terms of real dollars, in terms of what's going to have to be paid out, is probably around a quarter of a trillion. It's slightly less. It's about $200 billion in terms of dollars today. But I would say that the greater cost is the misallocation of capital. Somebody did a study recently trying to calculate this. Now this is very, very difficult to calculate. You know, what would have been if? Kind of a calculation. They did a very conservative calculation and their very conservative calculation came up with a cost of the misallocation of capital being half a trillion dollars. Five hundred billion dollars. And that's straight out of our pockets, in a sense of standard of living. Not in the sense of maybe us paying out the dollars. But we're paying more for the goods that we buy and we don't have the goods that could have been, is it or not? Yeah, we are. The government bailed the SNLs out as it had promised. They paid off all the deposit and so on. The cost of that bailout goes straight to taxpayers and we'll be paying it off for years and years because they they issued bonds in order to finance it. So, you know, our children are probably paying off some of that. Now think about it, two hundred million dollars, that's the size of the federal budget deficit for any given year and then half a trillion of indirect costs. So, talk about a huge cost and this is just one industry, one small segment of the financial industry with a few regulations. Financial markets and institutions in this country are the most regulated business in the country and they are the most regulated financial they are more regulated than in any other western country. They are more regulated in the US than they are in Japan. They are more regulated in the US than they are in Europe. I think the government even exaggerated the problem in the 70 eggs by increasing the amount covered by the insurance and not allowing commercial banks to take over. The government managed during the 80s and if I had a whole class just in this I could show you this but the government managed in the 80s to do everything possibly wrong that they could do. From closing down SNLs too early to closing down SNLs too late to you know to to exasperating the losses because the regulators had the incentives to take on the same risk that SNLs were taking on. So, while the SNLs were managed by regulators they took on even more risks than they were taking before this the regulators came in and it's it's the whole 80s in SNL is a whole different course and it's it's fascinating what went on there. Leon? For the benefit of the class, I made a deal with one of the local SNLs about two and a half years ago about some of their property and I thought I knew about business because I hadn't had an experience but God I was amazed at how tightly they are held in the clutches of the government. They cannot bend over, they can squeak for that getting permission. Yes, yeah. I guess just the best way to explain the biggest cause or biggest cause of the failure of the SNLs is in the early 80s is just like you owe a thousand dollars and that you know you have to pay in a year and you have five hundred dollars in your pocket so you go and gamble that yes because if you if you if you lose you couldn't pay off the thousand dollars anyway and if you win you'll be able to pay it off and that's how managers behaved. Not only did the government do everything wrong but after they acquired the assets back then they sold them at a fire sale at like two cents on the dollar and I never did understand it. Some people made a killing in those. Interesting people that had driven the savings loans down would go form new groups and go around. Not necessarily. A lot of private entrepreneurs did it. A lot of extraxial employees for example have made a killing on some of these fire sales. They used the same appraisers that had gotten the SNL in trouble now. There was big skin. They used the same appraisers to assess the cost of the assets before selling them. I recommend the number of books on SNL crisis by Edward Cain who's very good. He actually predicted the SNL crisis in the early 80s. He wrote a book predicting exactly what would happen and then he wrote a book in the middle of the SNL crisis saying what was going on even though nobody would admit it and then he wrote a book at the end explaining what happened and he was on TV. It's not like he was hiding. He was on TV explaining it and everybody was denying it at the same time. He's a finance professor at Boston College. Was that a question? Does the same thing happen now with the FDIC? None of the fundamental problems have been changed. The same thing could happen again to our banking industry. If you look at the numbers, almost did. In 1992, 1,000 banks won the verge of bankruptcy. Some of the largest banks in the U.S. I think I had the numbers. I think it was like $600 billion worth of assets won the verge of bankruptcy in the end of 1992. The reason they didn't go bankrupt is the Federal Reserve basically lowered interest rates dramatically helping out the banks in order to prevent them from going bankrupt. But the FDIC has been bankrupt. In the end of 1992, the FDIC, which is the institution that ensures banks, not SNLs, was in the hole for $6 billion. Stop by any of the 133 Los Angeles area O'Reilly Auto Parts stores where you'll find everyday low prices on the parts you need to keep your vehicle at its best. Our guaranteed low prices ensure you're always getting our best deal. In fact, we'll match any auto parts store's price on any like item. O'Reilly Auto Parts, better parts, better prices every day. Hi, it's Jamie, progressives employee of the month, two months in a row. Leave a message at the. Hi, Jamie. It's me, Jamie. I just had a new idea for our song about the name of your price tool. So when it's like, tell us what you want to pay, hey, hey, hey. And the trombone goes, blah, blah, blah. And you say, we'll help you find curb options to fit your budget. Then we just all do finger snaps while choir goes, statement's coming at you. Yes, no, maybe. Anyway, see your practice tonight. I got new lyrics for the rat break. Progressive casualty insurance company and affiliates price and coverage match limited by state law. Yeah. The other industry is the insurance industry, which is is based with potentially the same crisis because of rising interest rates and trying to. Yes, and you could have similar coincidences. Luckily, they don't have the positive insurance. Yeah. With regard to the misallocation of resources, granted regulation played a big role, but perhaps even bigger role was inflation and the swings in inflation, which caused enormous misallocation for real estate because it it distorted, I think, real estate value. See, it's yes, but part of the distortion and commercial state came from all these funds that there's no one willing to pay. So developers said, hey, you're giving you cheap money. I'll build and I'll take the risks because the money's so cheap what I don't have that much to lose. But you're right, but it's difficult to separate because who causes inflation after all? And so these are linked and yes, a lot of it has to do with the tax system. Who brings that about? So all of these could theoretically fall under the umbrella of regulation. It's a government intervention in general. But let's look at some others because we're running out of time. Not only is their misallocation directly because of these regulations, but also because of the false signals that are generated. False prices, for example, commercial real estate is suddenly popular. Other people enter into commercial real estate thinking that this is a good business because they're assuming the market sending them the correct signal. Prices now don't mean as much. Just one other example that I won't elaborate at this point, you can ask me after class, insider training. The fact that we have laws against insider trading makes the prices in the market less efficient, less revealing. If we allowed insiders to trade, prices of stock would be more revealing of information, more informative, therefore would provide a better guide to allocating capital and to providing incentives for entrepreneurs. So that kind of goes under the guise of misallocation of capital. A second effect of regulation is the misallocation of human resources. Thought, effort, money is spent on ways to get around the regulation and to deal with the consequences of regulation. But the amount of the quality and quantity involved in the thought of how to get around all these constraints is phenomenal. If you think about these markets, these markets to a large extent are being created in order to deal with the effects of government intervention. For example, you wouldn't have interstate futures, currency futures if you didn't have the government printing money. If we want a gold standard there would be no need for currency and interest rate derivatives. And these are some of the largest markets that exist today in terms of financial markets. It is no accident that these markets came about when. When were the first interest rate and currency futures options swaps and so on? Late 70s. Why? What happened in the early 70s? We went off of whatever was left of the gold standard. Bretton Woods, which was a pseudo gold standard, we went off the last remnants of that inflation at the same time went up. Suddenly we needed these. So a large segment of our financial markets which exist today would not exist if not for government intervention. Think of the resources involved. You know who these people hire? They hire physicists exactly and mathematicians. They don't hire my students. Finance students are not good enough for these guys. They need people who can deal with complex abstract mathematical models because of the kind of modeling that goes on to devise these instruments. Wouldn't still currency options training be useful for people to export? Probably not because once you were on a gold standard, A currencies would fluctuate very very little. Now that's assuming everybody was on a gold standard not just the United States. Currency would fluctuate very very little and I would say that whatever fluctuations they were, you would that risk would be absorbed in the course of business. The only reason you need these instruments is because of the large fluctuations. That's again taking us off our topic but I don't think you would ever, you don't need a hedge against small risks. The only thing you buy insurance against and you buy and you take hedges out against are large risks and I think to some extent businesses today overuse hedging because I don't think they need a hedge every little change in interest rates or every little change in currency. It is the risk that the changes will be big that is what you should hedge against. So the regulation distracts entrepreneurial talent to money making ventures that would not exist in unregulated markets. You can make money in devising ways of getting around regulation. Make a lot of money. I would claim even some of what Michael Milken did and we'll talk about this when we talk about restructuring even some of what was going on in the 80s where people made billions or tens of millions of dollars. If the markets were not regulated they would not have had to do what they did and they might have been doing something else that might have been more productive. Now the real cost of course is everything that could have been but isn't and that is of course the one thing we can't measure. It's that parallel universe where everything is unregulated and we can't really compare. We don't know how good things could be. We just know they would be better. For example regulation bring about a lower savings rate because of the uncertainty involved in the future people save less. They shorten our saving horizon. They shorten our investing horizon because of inflation, because currencies, because of general regulatory uncertainty and what's going to happen in the future. We don't make investments on long horizons. Investments today are shorter than they would otherwise be both for businesses and for individuals. Markets are less efficient in allocating capital. We have a lot more booms and busts than we would otherwise have. As I said the SNL crisis is a classic example of big bust. 1987 October the stock market crashed by 25%. I would say there's a relation there to regulation. One of the causes was regulation and hopefully we'll have time and I'll talk about that. Ultimately what regulation brings about is a lower productivity of labor than otherwise would be and a lower standard of living. Now if I was looking for analogy in biology for what it is that financial markets do. Dr. Binswanger likes to show the parallels between economics and biology and I think there are a lot of such parallels. Then I would say the financial markets institutions are the heart and circulatory system of an organism. They allocate the capital or the blood if you will to the various organs and the organs that need it most if you're running. Your leg muscles will need the blood more. Those are the organs to which the blood will go just like in an economy. Those who are more productive will get that capital because they can offer a greater return. Now when I thought of this I remembered that there's something similar some similar reference in Atlas and I went looking for and who would talk about finance in Atlas, Midas Mulligan. So I went looking for some quotes from Midas Mulligan and this is what Midas Mulligan, how he describes part of his business to the agony in the valley. He says my business is blood transfusion. My job is to feed the life fuel into the plants that are capable of growing. My blood bank is gold. Gold is a fuel that will perform wonders. But no fuel can work where there is no motor. Because the motor is the entrepreneur, the businessman, the innovator, the person with a new idea. Regulation is like a disease. It's like a virus attacking the body. Now think of a blocked artery. What does the body try to do when an artery is blocked? Tries to find a way around it, right? There you go. Collateral circulation. A lot of energy is exerted in trying to find a way around it. Just like in the financial markets a lot of energy is exerted in trying to find ways around regulations. Markets are developed in order to get around regulations. And believe me there are hundreds of these examples. If we had more time we could go through them. At some point though, just like in biology, the virus will kill you. And in financial markets the regulations will kill you. They will destroy the industry. As they destroyed, for example, the SNL industry. So you can fight them, but it's not guaranteed that you can win. Okay, any questions on that material? I have enough time to start the next material because I'm way behind it. I'll tell you what they say is the reason why it's a good thing to have deposit insurance. Which is it prevents runs on bank. What they say is there's a net loss to the wealth of this nation by encouraging people to leave money without having to worry about it. And if that insurance wasn't there probably other people would just stash them in mattresses. The simple answer to that is it's nonsense. And there are a number of reasons why. One is you have to look at why there were bank runs to begin with. And one of the biggest reasons for the bank runs in the early 30s were political. And a result of government policy. Of government mismanagement of the gold standard. Or of the threat that the government would go off of the gold standard. What were people doing? Running to the bank to convert their paper money into gold. So that's one. Second, our markets are fairly sophisticated. My students always say well what my students say is how would we know? Let's say there was no deposit insurance. How would I know if this was a risky bank or not a risky bank? Now I'm a finance student maybe I can read the balance sheet but how would people know? Well what would be a market solution to that? You know you're all young entrepreneurs. What would you what could you offer? A profit making opportunity to solve this problem. Rating. You'd have just like you're rating agencies and insurance companies. And a bond. You'd have a rating agencies of banks. They would have to they would want for competitive reasons to post their rating on the bank window. Maybe private insurance markets would develop. I mean who knows. Richard Salisman doesn't think private insurance markets would develop. I don't know. I would say let's see. But there would be solutions. The market has always solved these kind of problems and there would be solutions. I can think of a few and I'm sure I can't think of a fraction of what would actually develop. So I believe bank runs were a phenomena primarily of uncertainty created by government policy and that we live in a such a sophisticated market today that there would the the market solutions would develop to solve those problems. That would be my answer to that. Yes. Yes. Well you've got the biggest robber of all in the whole world telling you that they're going to stand behind everything. Yes. Okay let me let me start on this topic just because otherwise I'm going to be way way behind. So we've covered now the productive vote. So we know what the good is. We know the importance of financial markets and institutions. We know we cannot survive without them. Yet we know that their tax against them are horrible. We know their continuous under attack and the question is why. If they're such good guys they're so productive then why is it that they are continuously under attack by our media, by the press, by our intellectuals. And I'm going to divide this into two. One is why is this so for the common man. For the person who doesn't know any economics doesn't really understand these complex transactions. So what is what is the reason he is antagonistic towards financial markets and the intellectual and what are the philosophical reasons that they are antagonistic towards financial markets. So let's start, please make a make a start with the common man. I would say the primary reason here is ignorance. They just don't know. Now I'd like to read you a quote from Heislett's economics in one lesson. This is from the introduction. He says the art of economics consists of looking not merely at immediate but at the longer effects of any act of policy. It consists in tracing the consequences of that policy not merely for one group but for all groups. In other words economics is not about our raise taxes, revenue will increase. It's about what else is going to happen? Well how does that affect incentives of people to work? How does that affect the yacht building industry? How does that affect other industries? How does that affect allocation of capital? It's all these secondary and third level and fourth level effects that are real interesting. Where the economist should really be focusing. Yet those are the levels that are the most sophisticated, most difficult to figure out. Those are the levels one cannot expect the common man to see. And those are the levels that most economists when you hear them on the news programs on TV don't show you. All they show you is that first level immediate effect. What do people see? They turn on the TV on the news. They are showed a few people making lots of money. Very very rich. Then they see layoffs. They see people losing their jobs. And they see firms and companies broken up into pieces. And then some economists or the newscaster somebody will make the link between the people getting rich and the layoffs. You'll say the people getting rich are the ones responsible for the layoffs. It's the CEOs, it's Wall Street. Now who does the common man relate to more? The very very wealthy person who's got this this job on their 52nd floor in Manhattan or the labor or middle manager for that matter in these days who's just lost his job. Well he relates to the losing of the job a lot more than the making of the millions of dollars. And he accepts that connection. He accepts the connection between these people are making money at the expense of these people being laid off. It's very perceptual and it's presented to him in perceptual terms. He doesn't think about okay why are these restructurings going on? What is the effect? How come unemployment is going down even though all these people are losing their jobs? Maybe they'll find more productive jobs elsewhere. Maybe capital is better allocated this way. Those incredibly abstract ideas. And we're talking of people who live on a very perceptual low level of abstraction level. And that's they can't get to those other abstractions. And it is whose job to present that to them. That logical sequence. It is the intellectuals job. In addition they are presented with terms like junk bonds. Now I ask my class whenever I teach I do this in every single class because because my students have to have this pounded into them. Ask them what's riskier? A junk bond or a stock of the same company? What's riskier? A stock. A stock is always riskier than a bond even if the bond is called junk. Because if the company goes bankrupt the last people to get paid off are the stockholders. So putting the word junk in front of the word bond which a newspaper man did in the early 80s and it's stuck tells the common man what? Tells him there's something wrong here. There's something spooky there's something very very risky. And over half of my students say the junk bonds are riskier than stocks. Even though these are finance students they've taken classes where they know that stocks get paid off. Because they latch on to the words. They latch on to these to the terminology. What was the original terminology? High yield money. Okay now this is continuously reinforced by intellectuals. They teach wrong theories, they teach economic fallacies, not only don't they show the right connections they show the wrong connections and they coin terms like hostile takeovers, predators, and junk bonds. In addition, and this will be the last point, every time there's a problem, every time there's a crisis and this is something I think we all need to be really vigilant about the blame is placed on what? It is blamed it is placed on capitalism. Because people perceive and the economists tell us that we live in a capitalist system. And I think it's important for us to be vigilant when talking to people to emphasize the fact that this is not a capitalist system that we lived in a mixed economy. So that capitalism doesn't get labeled with the problems of a mixed economy. And I'll see you all tomorrow. Sorry to keep you over. Thank you. This course continues with lecture three. Use with lecture three. Use with lecture three. Use with lecture three. Use with lecture three. Use with lecture three. Use with lecture three. Use with lecture three.