Cold
Turkey for Financial Addiction?
By Dr James Cumes
The time for financial
detoxification seems to have come. Indeed it seems to be long past due.
The addiction started with the
junk-bond craze and the smart take-over merchants of the 1980s. Those junkies
were on relatively soft drugs and they were fringe people – most of the serious
investors and financial institutions saw them as market outlaws or barely legal
cowboys. They were what I then called "adventurers, marauders and
buccaneers." Some crossed the line and were convicted on serious felony
charges.
In 1988, in "How to become a
millionaire", I asked "How true is it that 'what is happening in the
financial markets today bears the same relationship to what happened in the
"go-go years" of the 1960s as Caesar's Palace bears to the local
bingo game'?" Were we, I asked, "turning the financial markets into a
huge casino?"
In the years that followed, we all
should have got the answer. Soft drugs gave way to hard. Addiction spread. The
drugs diversified; so did the addicts. Into the 1990s and dramatically more so
into the 21stcentury, many of those in the top-drawer financial world became
addicted. Many became more, more became most and most in the last few years
became all: the biggest and most respectable financial institutions,
financiers, creative investors and even regulators joined in with a sense of
benevolent enthusiasm that defied any remaining scaremongers.
Where everyone in the house is
crazy only the sane seem like fools. So it was when the financial addiction
spread everywhere. Then everyone who was not taking his daily dose of heroin or
cocaine or crack became the fringe-dweller, the oddball, the brake on progress,
the pooper at the greatest no-cash-down, how-to-spend-it shindig that our
planet has ever known. Debt piled on debt everywhere: in households,
corporations, public finances and international deficits, in magnitudes that
had never been even glimpsed in the most creative imaginations before.
But the universality of
drug-taking does not mean that deadly drugs will not harm and cannot kill.
The deadly nature of the addiction
was obscured by the extraordinary variety, complexity and obfuscatory nature of
much of the so-called structured finance: credit derivatives, commercial paper,
hedge funds, CDOs, CDSs, SIVs, ABCP and the rest. They all looked not only
creative but also splendidly professional and expertly-managed. Mathematicians joined
their creative genius to that of accountants and others to conjure up
"models" that were guaranteed, reliable, blue-chip, fail-safe. Even
the most respected rating agencies spread their Alpha ratings around with such
glorious abandon that anything else seemed to have gone out of style. Such was
the chorus of acceptance that these instruments came to be regarded, above all,
as secure as the banks or non-bank issuing or trading institutions confidently
presented themselves as being. So the
final accolade was conferred on financial instruments that in any world except
one in which the entire population had gone crazy, would have been condemned as
the deadly instruments of financial, moral and other ruin that they surely were
– and are now proving themselves to be. As one analyst writes: “Before this
mess finally ends, there are going to be scores more hedge funds, pension
plans, mortgage lenders, and possibly even banks carted out in a wagon wishing
they never heard the term "swap", "swaption",
"conduit", "MBS", "CDO", "CDS"
"SIV", "Mark to Market" and probably a dozen other terms as
well.”
Perhaps the credit derivatives, in
all their manifestations, were the most addictive. They were as modern and
creative as the latest technological marvel. From the initial concept in the
late 1990s, they gave a dream ride to the mostly young, very smart people who
were able to ride to financial glory on a tide which quickly swept along even
the most staid, respectable and financially distinguished institutions in America
and, in surprising measure also, around the world.
If some were spared addiction in
the early years, they became fewer and fewer right up to July 2007.The
regulators, including central banks, international agencies and others, did not
regulate the ever thicker jungle of financial enterprises and their innovative
financial products because more and more the addicts lay outside the banking
system and therefore largely or wholly outside their jurisdiction. The banks
did not stay aloof from “structured finance” of virtually every kind but they
managed their participation in it, for the most part, in ways which avoided
interference by the regulators – if, that is, the regulators might have been
disposed to interfere. Increasingly, they accepted some form of “moral hazard”
just as major banks at the very top of the financial heap did in their dealings
with Enron in the course of its fraud and failure at the end of the 20thcentury
and into the 21st.
So the addiction grew and spread
without restraint – it became a sort of global financial frenzy sans frontičres
- and the law-enforcement officers, having no powers of enforcement and/or no
will to enforce - either cheered them on or snored off at their desks.
Until now. Even yet, they are not
wide awake but they have now begun to stir.
When they do become fully alive to
what has happened, they will be even more appalled at the terrifying financial
situation that confronts them than many of us among the non-addicted are now. Their
attempt to resolve that situation in any way that can be called acceptable will
reveal both their culpable negligence in the past and, ultimately, their
despair of finding any “cure”, any “magic elixir” or any “soft landing” in the
period ahead.
They will discover that they and
the speculators, high rollers and just plain gamblers in global finance have
been indulging an addiction for which there can be no painless detoxification. The
addiction has persisted for too long and has become too deep and widespread.
To begin with, the addiction is
too huge. The “value” of the creative financial paper circulating the globe is
calculated, as close as one of our “experts” can reasonably count it, to be
$US480 trillion. The Bank for International Settlements (BIS) puts its count at
$600 trillion. In fact, we do not know what the precise sum may be but we do
know that it is so mind-boggling that it seems to lie outside all reality. What
is certain is that somewhere in that massive sum are debts that have to be
repaid and creditors who have to be satisfied; and we know that it is a domino
game. If the creditors of the first debtor aren’t satisfied, then they will
become, in their turn, defaulting debtors for their own creditors; and so on
down the line and around a global mulberry bush.
Global Gross National Product
(GNP) is calculated to be about $50 trillion a year. So the figure of $480
trillion is close to ten times the entire global annual GNP and $600 trillion
is about twelve times. Alternatively, we can say that the “notional value” of
the various pieces of financial paper circling the globe at the moment is
probably somewhere between 40 and 60 years of Gross National Product of the
United States. It is several times the estimated market value of aggregate
global wealth.
How much of this is
double-counting? How much of it requires the liquidation of real assets in
order to satisfy a structured-finance debt? We don’t know, just as we don’t
know the answers to many of the magnitudes involved in what is undoubtedly the
greatest, most complex and most intimidating financial problem that national
economies or the global economy as a whole have ever faced. Wordsworth wrote
about “Huge trunks and each particular trunk a growth of intertwisted fibres
serpentine up-coiling, and inveterately convolved.” He could well have been
writing about our current financial instruments and the "system" they
have contrived for us.
The unease, verging on panic,
about sub-prime mortgages has given us a glimpse of what is ahead. But, let us
be very clear, it has been only a glimpse. Sub-prime securitised mortgages are
only a relatively tiny part of the huge credit and debt structure involved in
what we may group under the generic name of derivatives. They include credit
derivatives, hedge funds, private-equity deals, mutual funds, pension funds and
the whole gamut of financial instruments that have flooded not only United
States markets but markets around the world, especially in the last five to ten
years.
However, if the sub-prime crisis
has given us only a glimpse, it has also given us a terrifying preview of what
is yet to come. The first clear point is that the various pieces of financial
paper do represent debts that have to be repaid or somehow liquidated. Creditors
demand their money and debtors must find the money to pay them, with the
penalty for default heavy losses with possible bankruptcy. The latter is
especially likely in a world in which credit has become tight.
The second crucial point is that
we don’t know the “value” of the financial paper except in nominal or notional
terms. On the books of the debtor it is “marked to his model”; and, most
likely, on the books of the creditor, it is “marked to the model” of the
creditor in the same way or even more advantageously. However, the only thing
that really matters in the end is how it is or will be “marked to market” at
the moment of time when the market is called upon to pass judgement by giving
it a cash value. In this regard, we should note that financial assets worth trillions
of dollars are from Over-The-Counter (OTC) transactions for which there is not
and never has been any “market” to mark them to. They will not have an
authentic market value until the moment comes for the deals to be liquidated in
one way or another.
In a bull market, financial paper
might be sold well above the “mark to model” price; but it is not at that point
that the holder might be most likely to sell – or, most importantly, be forced
to sell. It is when the market has become nervous, when confidence has been
diminished and when the bears have begun to crowd the markets that the price
will become most relevant and crucial. Then, with the markets as we have seen
them in the past two months, the price of the securitised paper is likely, as
one analyst put it, to go “Pouf!” In other words, as we have seen with some of
the paper of such a previously highly respected firm as Bear Stearns or a major
bank such as BNP, the paper can become or be seen to be worthless or very
nearly so.
Does that result in real losses? For
someone, it certainly does, however much the institution may say that it is in
a position to bear those losses - of a few billion, tens of billions or, in
some cases, hundreds of billions of dollars.
Recently, the spotlight has been
on sub-prime mortgages; but this is only because the collapse – the inability
to pay outstanding debt – happened to appear there first. We should have
expected that. The mortgages or a high percentage of them were, it would seem
deliberately – certainly with a high degree of studied negligence - designed to
fail. They did fail; but the important thing is that, even in the wider housing
mortgage market, prime mortgages have been failing too – and they will continue
to fail. Household debt in the United States and some other countries is more
enormous and potentially more crippling that it has ever been before. In more
and more instances, the mortgagee will be unable to service his debt – a real
debt, whose failure, in aggregate, will have a real impact on the national and
global financial situation and, eventually but fairly rapidly, on the
productive economy.
So the infection will become an
epidemic which will spread to the whole housing market; and markets other than
housing have been deeply involved in the structured-finance caper. Credit
derivatives of all kinds, a rapidly proliferating range of hedge funds,
private-equity groups and the rest have shown no hesitation to exploit smart
financial and above all, highly leveraged opportunities wherever they may have
been offering. Most of that enterprise has thrived – and can thrive only - in a
booming market in which more money flows into the schemes than goes out; so
there is a Ponzi element in much of current creative financial enterprise that
makes its collapse as inevitable and potentially as destructive of value as the
sub-prime mortgage debacle has been.
When the net inflow of funds into
these schemes becomes a net outflow, the whole structure must inevitably begin
to crumble. Hedge funds have been particularly – perhaps we can say, inherently
- susceptible to collapse. Thousands have come into existence in recent years;
and thousands of them have gone out of business. That has happened
characteristically even when markets were booming. In recent years, those who
exited the business were fewer than those who entered. But now that the boom
has turned more clearly in the direction of a bust, hedge funds heading for the
exits have been increasing in numbers. If the exits are not crowded yet, it
won’t be long before they will be. Only those in the more traditional style of
hedge funds – hedging genuinely for themselves and others who may be their
clients – may survive.
One analyst has suggested that the
current credit crunch has given us a chance “to see the hedge fund emperors
without their clothes.” It has also been “an opportunity for investors to get
some insight into an industry whose activities are often cloaked in secrecy and
which has wandered far from its original purpose of hedging volatility” (Sharon
Reier). That original purpose was to manage market risk by, for example,
hedging long and short positions with modest leverage. The contrast with the
funds as between 6,000 to 10,000 of them have now evolved is stark. Even of the
widely respected “quants” – the computerised quantitative or black-box models
of the mathematical whizzes - Donald Pinto, an experienced hedge-fund manager
himself, is quoted as saying that “The programs are quite sophisticated. They
do work in stable markets, but they have a fundamental weakness. There is no
room for judgement. When markets behave erratically – as they have recently –
the inability to use common sense to make investment decisions, combined with a
high level of leverage, is a recipe for disaster.”
With the hedge-fund industry
claimed currently to be the volatile repository of about $US1.7 trillion, this
can only give cause for acute alarm.
The fragility of the “system” can
be seen further by analysing each of the various elements contained in what is
high-risk, speculative, “ownership” investment. That “investment” looks
principally to profits through asset appreciation. The prices of assets are
driven up because of a speculative fever and that fever, as in many asset-price
booms of the past, is embedded in a conviction or expectation that it will feed
on itself to drive prices to ever more feverish and ultimately unsustainable
heights.
These booms persist only as long
as funds are there to nourish them. If the flow of those funds diminishes or,
more particularly, if their flow is reversed, the booms have historically and
characteristically been prone to sharp collapse.
The present financial situation is
more complex than any we have known before and has tended to draw in all
markets– for stocks, real estate, currencies, gold, commodities and the rest –
if only because what we may call the broad category of “derivatives”
characteristically “derives” from those markets. Despite this spread and
complexity, we may still postulate that the fundamentals of market behaviour
remain the same.
It is in that context that we
might consider some elements in the present global financial situation. One
such element is the carry trade. Its essence is that money is borrowed in a
market where borrowing costs are low and invested in markets where returns are
high. This has meant borrowing, for example, in Japan or Switzerland and
investing in, for example, Australia or New Zealand – or, for that matter,
Iceland or the United States.
The carry trade has apparent
advantages. It is part of the financial regalia which enables the
high-consumption economies to keep right on consuming; but that coddling of
debt-based consumption also has its price, particularly by creating huge trade
and payments deficits and by stimulating the export not of products of domestic
industry but of the industry itself. The United States dollar, for example,
loses value vis a vis “producer” currencies and commodities, its role as a
reserve currency is undermined and volatility – on which speculation thrives –
replaces the stability derived from, for example, gold or the system based on
the dollar which in turn was related to gold contemplated under Bretton Woods. Stability
is replaced by an anarchy which encourages movement away from production and
fixed-capital investment into asset-price speculation and “ownership”
investment.
Another part of the price is that the tap might be turned off at
any moment and perhaps quite sharply, if the carry trade reverses – and, sooner
or later reverse is what it certainly will do. If the Japanese yen appreciates
or threatens to appreciate sufficiently or if interest rates in Japan move up
significantly, a robust carry trade will rapidly become a robust unloading
exercise. The outcome can then be that asset-price booms are sharply collapsed
and, down the line a little, consumers too are required to adapt themselves to
more Spartan living. The export-driven economies which are based on high
consumer export markets will also be hurt. So the markets will carry the impact
of speculative volatility from one point to another.
As part of this, we might just
take a quick look at the way in which the housing market in Australia has
appeared to evolve. Recent years brought a frenetic boom to Australian
residential property especially in Sydney and, to a lesser but significant
degree, in Perth. The boom then showed signs of slowing, again especially in
Sydney. That tendency to slow still applies to the Sydney market, although
prices even there have recently seemed to be moving up again. However, what
seems to be especially worthy of note at this point is that prices in the
capitals of most of the other states seem to be heading or to have already gone
into frenetic mode. This is despite affordability for houses and apartments
having declined dramatically for the average buyer. So it would seem that much,
at least, of the persistent boom in housing is due to speculation rather than
to demand from the consuming public.
That suggests that funds have been
flowing into the housing market, presumably in a quest for capital gains
through asset-price inflation. Where have these funds come from? Frankly, I do
not know from any reliable data available to me; but a reasonable hypothesis
may be that some of it may be foreign money, possibly from the carry trade,
seeking to find profitable outlets for the money borrowed cheaply in – most
likely – Japan. The housing that is being bought in Australia, except possibly
some in Sydney, would seem to be different from the largely alpha-luxury
property which, for example, is being bought in London by foreign money seeking
speculative outlets for investible funds; but something the same kind of
speculative stimuli may be producing much the same kind of ultimately
unsustainable property boom in Australia.
In either the Australian or the
London case, a collapse of the housing market – along probably with a collapse
of other asset markets - is inevitable. It is a question only of when rather
than if.
That “when” might now to be rather
close. It could get under way as early as the next couple of months. October
and November have seemed to be dangerous for events of this kind in the past. The
stock-exchange crashes of 1929 and 1987 are examples. The current nervousness
on Wall Street and stock markets around the world may quickly flow on to asset
markets everywhere.
Central banks now recognise the
dangers of a meltdown in credit markets and seem ready to do whatever they can
to prevent it. They have already made available to banks at least half a
trillion dollar-equivalent loans to give them extra liquidity. The Fed has cut
the discount rate. They have kept the more general interest rate or “bank rate”
on hold and some might be about to reduce it. But the feature that is perhaps
of most significance and that carries the most startling risks is their
willingness, already demonstrated by the Fed, to accept “securitised” paper,
even relatively high-risk collateralised mortgage paper, as security for their
loans to the banks. That process would seem to mean that that paper would
become, in some measure, a substitute for the Treasury bills or similar
securities of other central banks which have been used in traditional
open-market operations in the past. Already the limited acceptance of this
paper is a token of its extraordinary evolution towards respectability. The
junk bonds or creations of what I once called the “adventurers, marauders and
buccaneers” have now been endorsed by central banks as seeming to belong in the
same ball-park of acceptability as gilts or Treasuries.
This may be, on the one hand, the
only real way to deal effectively with the disruption to credit which this
paper has caused and threatens further to cause on a vastly greater scale. Only
in this way perhaps can the vast burden of intrinsically speculative debt be
“neutralised.” On the other hand, if the practice is indulged in any sufficient
way for it to be effective in its “neutralising” function, it will destroy the
American and perhaps other currencies and put the entire global financial
system as we have known it at grave risk.
To make "liquidity"
available to the banking system is not to be certain that the banking system
will use it in a way to keep the credit markets adequately open to normal
commercial business. At the same time, if the central bank proves willing to
accept any amount of this securitised paper, then it would mean the injection
of mountains of paper currency into the financial system, presumably starting
with the United States but possibly or probably extending to other major
financial markets and ultimately polluting the entire global system. If the
"notional value" of derivatives is something of the order of $600
trillion, we do not have to postulate that the central banks will absorb and
“neutralise” all of this paper. Even if they were to absorb only 10% of the
notional value, this would amount to about $60 trillion - more than the Gross
National Product of the entire world economy.
The figures are so staggering in
themselves that the mind boggles; but perhaps the even more important thing is
that we - and the central banks - cannot know the true extent of the problem
that confronts them. Will they have to accept "only" 10% of this
paper or will 1% turn out to be enough? If only 1%, what impact would
acceptance of paper to that amount - $6 trillion - have in unfreezing the
credit markets? Would it also mean that central banks would have embarked on a
course of hyperinflation which would make the United States dollar and possibly
several other major currencies worthless? There would then have to be an issue
of new currencies as there was after the hyperinflation in Germany in the
1920s. There would also have to be a fundamental re-negotiation of the ways in
which the global financial system would operate.
All of that would take time. While
it was going on, national economies and the global economy could be brought
near to standstill. Economies might have to resort to some form of barter as
the only way in which trade could continue securely to take place. Unemployment
would become socially devastating. Many personal fortunes would disappear. There
would be a whole re-ordering of societies and of relations between countries
that might offer the most terrifying outcomes in terms of conflict of all
kinds, including wars - civil, regional and worldwide.
Some analysts have been contending
that the prospect of a depression - another great depression of global
dimensions - has been feared for so long now that it will not be allowed to
happen. That is too optimistic. Governments and central bankers will not want
it to happen but they have so far failed so miserably to prevent or deter us
from stampeding to the brink that, whatever their motives may be, they seem now
unlikely to be able to stop us from going over the edge.
Therefore, the best that we can
hope for now may be that governments, central banks and others will apply such
palliatives as they can without allowing their support of speculation to add
further to destruction of the global economy and financial system, while at the
same time embarking on national and international measures to restore primacy
and vigour to fixed-capital investment, productivity and production in the real
economy, national and global.
That raises the question of the
impact and its extent that financial collapse will have on the real economy –
the productive economy. The short answer is that it must inevitably be
somewhere in a range from severe to devastating.
The immediate depressive effect of
what we have already is likely to be sharp and severe. Employment in the United
States appears already to have moved down sharply. This is largely in housing
and construction which contributed so much to growth in the recovery and boom
years after 2001; and in associated industries such as durable goods, retailing
and distribution, real-estate agencies and associated professional and legal
services. Consumer demand which drew so much of its vitality from the housing
boom will be severely hit. Credit-card debt will have to be wound down. Auto
credit is likely to diminish both in demand and supply and the auto industry
could suffer severely. So the impact of credit problems will flow through the
national economy and must also impact on the trade which the United States will
be able to conduct with the rest of the world.
The dollar is almost certain to
decline in value, perhaps precipitously, especially in gold and key-commodity
terms and force a reduction in demand for imported goods. This will be in part
beneficial for American exports; but industries especially in the more basic
consumer sectors are unlikely to be able to replace, at least in the short
term, supplies from overseas. No longer the consumer-without-limit, the United
States will almost certainly infect other countries with its slowdown,
recession or depression and that in turn will reduce growth, investment,
employment and output around the world. Even the boom in commodities, though it
might survive more robustly than other sectors, will certainly be affected and
diminished, as demand collapses in other sectors. In other words, we are likely
to see the characteristic snowball effect on trade and growth that we have
experienced in similar – though almost certainly less devastating –
circumstances in the past.
Some countries, such as China,
which have more effective regulatory control of their economies as well as the
inherent size and strength to “go it more nearly alone” may transit the worst
of the coming crisis less painfully than some others.
To emerge from this crisis or
complex of crises, we will need to resume attitudes of mind and policy which we
had after 1945. After twenty years of world depression and world war, there was
then a widespread passion for rebuilding national economies and the world
economy on a sound basis of stability and growth, through multilateral
cooperation for peaceful change.
Now we need to restore value to
what produced real income and wealth for us in the past. We will need national
institutions which can help us restore that value; and we will need to rebuild
our international institutions. The United Nations and the host of associated
or independent international institutions have proved to be useless or worse
than useless, especially over the last three to four decades. Their achievement
has been to bring us to the brink of a tragedy – economic and financial in its
outward aspects, but with deep political and strategic implications - which
threatens to be the most cataclysmic to confront us during all the years since
the advent of the Industrial Revolution.
So in a sense, the task which
confronted us in 1945 is the task which confronts us again: to rebuild the
world to a better pattern of economic and financial policies and practices and
to do so cooperatively and imaginatively with the participation of all those of
whatever backgrounds who share our objectives of positive and peaceful change. It
is a huge task. It calls for cooperation among all countries and all regions,
all races and all faiths if we are to see our way through it safely.
In tackling that task, we must
start now. We have just seen an APEC Summit in Sydney which has been an
exercise in futility, both discussing vital issues in ways that could serve no
purpose and ignoring issues whose neglect could bring us to the brink of
self-destruction of much of human civilisation. The APEC meeting reflected the
impotence and irrelevance that a plethora of international gatherings and
self-styled “Summits” have displayed in recent decades. We must not persist in
flagrant indulgence in this empty, exhibitionist futility.
The process of building new and
effective international economic institutions was set out some years ago in my
proposals for “Victory Over Want” (VOW). These proposals have been developed
further in my proposals for a World Economic Authority and a World Development
Authority put forward in my latest book, “America’s Suicidal Statecraft: The
Self-destruction of a Superpower.” There are other proposals being put forward,
many of which are worthy of careful and urgent consideration.
However, with the best will in the
world and with the utmost cooperation among the world’s major powers, creating
effective international agencies will take time. Until then, it seems inevitable
that we cannot avoid some elements of a “cold turkey” detoxification from the
addiction to which our economic and financial policies have delivered us. That
“cold-turkey” detox threatens to be the most painful experience that the
national economies and the world economy as a whole have suffered in the two or
three centuries of the Industrial Revolution. It must be our objective
therefore to keep this phase as short as we possibly can and to move to the
phase of rebuilding through effective national and international measures and
institutions as soon as may be practicable.
That is the imperative which we
should now acknowledge and should seek to satisfy with all the energy, creativity
and urgency we can contrive.