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398 • International Tradebringing in yet more speculators. When prices are rising faster than interestrates, speculators leverage their investments with borrowed money.Higher asset prices in turn provide ever more collateral for loans. Even ifspeculators know an asset is overvalued, they may continue to invest onthe assumption that other speculators will continue to drive up the priceeven further. Ponzi investors jump on board. Eventually the pool of investmentmoney, much of it borrowed, is inadequate to continue drivingup demand, and prices begin to fall. We have already explained the dynamicsof the resulting crash. Under the Efficient Market Hypothesis, theresulting crash is considered a “market correction.” Under the FinancialInstability Hypothesis, the resulting crash is considered inevitable in theabsence of regulations that limit leverage, and government intervention istypically necessary to bring the economy out of the resulting recession.Leverage, or the purchasing of investments with borrowed money, allowsspeculators to dramatically increase their profit margins but also increasesthe chance of a system-wide crash. If an investor buys a milliondollars in financial assets that pay a dividend of 12% per year, borrowing$900,000 at 7% to do so, she earns $12,000 from her own $100,000, plus5% of $900,000, or $45,000, for a total gain of $57,000 on her initial investmentof $100,000, giving a rate of return of 57%. However, if the investmentfails to pay at least a 7% dividend, she may be unable to pay theinterest on her loan and thus default on it.In 2004, the U.S. Securities Exchange Commission, a governmentagency responsible for regulating the securities industry, decided to allowinvestment banks to take on far more debt, which is another way of sayingthat they were allowed to leverage their assets more aggressively. Investmentbanks quickly began to borrow as much as 32 times their totalassets, often using this money to purchase securitized mortgages, providingbanks with yet more money to loan. When the sub-prime mortgagesdefaulted, many banks were unable to pay for the money they had borrowedand either defaulted or had to be bailed out by the government.Moral hazard is another contributing factor to financial crises. Importantfirms such as big commercial and investment banks and major carmanufacturers know that if they fail it will cause a widespread economiccrisis. The government views them as Too Big to Fail, and the firms knowthey will be bailed out if they make risky investments that fail catastrophically.Another form of moral hazard is when managers of firms earn hugebonuses based on short-term profits, which they do not have to pay backif an investment later goes under (this form of moral hazard is referred toin the industry as I.B.G.—I’ll be gone). Similarly, in the buildup to thesub-prime mortgage crash, U.S. banks “securitized” sub-prime mortgages—theybundled mortgages up into securities, which were then soldto other investors, which provided the banks with money to make more