Features | Economy

Regulate This

In 1998, the former chairman of the US Federal Reserve, Alan Greenspan, told an annual meeting of the US Securities Industry Association, that money itself was undergoing a dramatic period of change.

In 1998, the former chairman of the US Federal Reserve, Alan Greenspan, told an annual meeting of the US Securities Industry Association, that money itself was undergoing a dramatic period of change. “The financial instruments of a bygone era, common stocks and debt obligations,” he opined, “have been augmented by a vast array of complex hybrid financial products, which allow risks to be isolated, but which, in many cases, seemingly challenge human understanding.”

Greenspan was right. A new, post-modern era of money was well under way. The recent upheaval in the global financial markets, which started with apparently marginal problems in the American property market, the so-called subprime mortgage crisis, is beginning to look like the first comprehensive test of that post-modern finance. Global financial markets have for over two decades been developing characteristics that create a typical post-modernist anxiety: “What is real?” The anxiety is now reaching fever pitch, in part because so little is understood about the threat. Like much of post-modernism, the complexity is apparent but the truth remains elusive.

Consider the progression. In the pre-modern era, money was a tangible thing, often gold, whose value was equivalent to what it denoted. The modern period began when, in addition to bank lending, capital was raised in the form of equity (shares) and bonds. Now, most developed economies have a reasonably equal balance of the three. It had the effect of greatly expanding the quantity of money, although until the removal of the gold standard in the 1970s, the volume was constrained by how much gold was available. There were also heavy restrictions on cross border flows of capital.

The post-modern period first started to emerge in the mid-1980s, when financiers created a layer above – a meta level – that sharply increased the quantity of money again. It began with excessive lending to Latin American countries. Western bankers, flush with petrodollars from the Middle East, began with a modernist assumption – that sovereign governments would never default on debt – and constructed a massive artifice of credit for those governments. They loaned money recklessly until the governments did exactly what they were not supposed to do, and defaulted. Arguably the first post-modern crisis ensued, imperilling the world’s banking system.

Techniques to blur the line between debt and equity (hybrids) were next. Financial engineers found ways of creating debt-equity hybrids which were in turn used to raise much larger quantities of capital. The notorious “entrepreneurs” in the late-1980s in Australia were mostly using this method; the “junk bonds” devised by Michael Milken and Ivan Boesky were a similar sleight of hand.

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These were early examples of the coming dangers, but post-modern finance really got underway with the sharp rise of the derivatives market in the mid-1990s. Derivatives are financial instruments, derived from primary transactions, which are meant to insure traders against adverse market movements. For example, a futures contract on the wheat price to ensure that a minimum price is paid when the wheat is delivered, is meant to be a form of protection against adverse market movements.

Derivatives are supposed to be on the margin, but they now occupy centre stage. The catalyst was the de-regulation of global financial markets. As governments removed controls over capital flows – controls which were designed, among other things, to minimise risk – the quantity of cross-border capital flows sharply increased. So did the risk, especially the risk of volatile currency movements. In response, financial markets started using derivatives to manage the risk. It was quickly discovered that large profits could be made out of this meta-level of trading.

Governments soon found themselves outgunned, beaten by the post-modern financiers. The seminal event was Black Wednesday, September 16, 1992, when hedge fund trader George Soros took on the Bank of England in an effort to break the European Exchange Rate Mechanism (ERM), a government backed structure for keeping European currencies trading within a range against each other. He won. The ERM was dead. So, too, was government’s control over the quantity of money.

Derivatives trade is now massive; the post-modern financiers are rampant. The layer of transactions above the merely economic is assuming a size that is out of all proportion compared with the so-called “real” economy. According to the Bank for International Settlements, about $US3.2 trillion is transacted in the global capital markets each day, about four fifths of which are derivatives. Global GDP is a mere $US50 trillion, about 18 days worth. The result is something like two mirrors facing each other: money being endlessly made from money, risks being continually taken with the management of risk. According to the International Swaps and Derivatives Association, the credit derivatives market has grown from an estimated total notional amount of nearly $US1 trillion outstanding at year-end 2001 to over $US34 trillion at year-end 2006. Such growth can be very lucrative for participants if they can take just a small percentage of the trades. But the eventual dangers are now becoming all too obvious.

In such an environment, the question, “What is the quantity of money?” has no ready answer. On the face of it, what is happening in the global derivatives market should be seen as a dangerously inflationary expansion of the money supply, although it is not viewed that way because it is not included in government statistics. And in any case much of the activity is notional, that is, many derivatives are not realised. The US Federal Reserve’s response was simple enough. They abandoned conventional estimates. In 2005 M3 was rejected as a measure of the broad money supply. The consequences for economic and policy analysis are profound. With no reliable way of assessing the quantity of money, how can the Fed exercise its traditional mandate of controlling the money supply?

The Post-Modern Malaise

Post-modern finance, and post-modernism generally, have three persistent problems. One is the tendency for the meta level to dominate the primary. In the post-modern computer world of virtual reality, for example, neat understandings of reality are elusive. Yet the meta level always depends on a primary level for its existence (the meta has to be above something). Defining a healthy relationship between the two becomes critical. Witness the practice of securitisation. Transactions such as house mortgages and commercial property loans are packaged up (securitised) and sold into  global capital markets as different levels of risk with different levels of return. The subprime mortgage crisis arose principally out of the use of collateralised debt obligations (CDOs) in which high risk debt was presented as relatively safe securities. Ratings agencies were co-opted (very willingly) into giving assurances that the new instruments had suitable risk profiles, and a highly profitable form of meta trade was created. Profitable, that is, until the assumptions on which it was based started to fall apart. Cue some of the biggest losses in modern financial history for investment banks and their unfortunate clients.

Two banks, Citigroup and Merrill Lynch, turned to foreign investors to raise a total of $US21.1 billion in fresh capital – mainly from outside the US – to shore up their balance sheets. Citigroup is warning of losses to come from consumer loans as it revealed a 40 per cent dividend cut, a $US9.83 billion fourth-quarter loss, $US18 billion in subprime-related credit writedowns and remaining exposure of $US37 billion to subprime mortgages.

The tale is typical of post-modern finance. The meta level (securitisation) is initially derived from the logic of primary transactions (loans) but as it grows it starts to develop a logic all of its own. When that logic starts to clash with the original logic, it is only a question of time before the meta-edifice starts to get into trouble.

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More troublingly, the underpinnings of the banking system, upon which the creation of the post-modern meta instruments are based (usually off balance sheet) are looking shaky. Analyst Kenneth Couesbouc argues that the three forms of bank collateral, stocks, bonds and real estate, are at historic highs, and seem to have peaked simultaneously. Moreover, it is unlikely they will stay at such levels. Couesbouc is probably overly pessimistic about shares, which do not seem especially over-valued, but he does make the point that the cyclical coincidence of these three forms of collateral, rising, peaking (and, he argues, soon slumping) is a rare occurrence. “It has facilitated an unprecedented swelling. But it also means that there are no secure forms of collateral to fall back on. As, apart from the three, currency is an obvious target for inflation. And gold is almost exclusively held by central banks and, anyway, there is nowhere nearly enough of it around.” The modern era foundations seem set to bring much of the post-modern superstructure down.

A second challenge when dealing with post-modern finance is the need to confront dangerous circular logic. Circularity is common in post-modern thinking (post-modern authors often write, for example, that the author is dead). Circularity is implicit in the very idea of globally de-regulated finance, the intellectual fad that took hold in the 1990s. What is capital? Rules about value and obligation. What does it mean to de-regulate capital markets? It is not possible to “de-rule” rules, any more than one can take the wetness out of water. It can only mean replacing existing rules with new rules. In this case, removing rules devised to protect against risk, which opened the way for the privatisation of risk management. This in turn led to the creation of a blizzard of financial instruments engineered to reduce individual risk that has created dangerous levels of systemic risk. De-regulation in other words meant changing the rules so as to give up the responsibility to regulate against excess.

A similar logical loop is evident in the claim that since global capital markets were de-regulated they have become more efficient. How is efficiency measured? By comparing quantity and time against money. Can money be measured against itself? “No”, if you want to make any sense. “Yes”, if you like the circumlocutions of post-modernist games.

Third, and even more pernicious than logical contradiction is the tendency for self reference which routinely leads a continual, if not exactly infinite, regress. An example is the creation of illusory collateral for securitisation, the soundness of which is unknowable but which can be priced. This was then legitimised by ratings agencies in order to pass the risk to insurers (such as monoline insurers), the profits from which are then used to start a new round of securitisation.

This self-reference has the effect of amplifying any problems. For example, the huge volumes in the CDO market were artificially created by banks essentially dealing with themselves. They created the instruments, then bought them, booking the profits and neglecting to check if there was sufficient liquidity in the market for the transactions to make any sense. Gary Crittenden, chief financial officer of Citigroup, admitted that the company made its massive write downs because “the market is simply not there to do it in size in any way and it would have been uneconomic to do it.” As analyst Pam Marten argues, the game of pass the parcel was deliberately orchestrated by the big banks. She writes that Deutsche Bank, Goldman Sachs and JPMorgan each took an equity stake in a private data firm, Mark-it, when they sold the company their proprietary database of credit derivative information. “What would have been the incentive for three big Wall Street players to build a proprietary database and then, in a magnanimous gesture completely uncharacteristic of Wall Street greed, hand it over to be shared with their largest competitors?” she asks. “One likely answer is that around this time regulators with a fetish for orderly paper trails had stumbled upon the fact that there was a growing backlog of credit derivative trades that were never officially confirmed between the parties, reaching a peak of 153,860 unconfirmed trades by September 2005. Of this, 97,650 trades were more than 30 days overdue; 63,322 trades were a stunning 90 days past due according to a Government Accountability Office (GAO) report.” Breakdowns in the self-reference are what causes crises. The credit crunch now affecting global markets began when the inter-bank market started to falter – banks stopped lending to other banks. Prices would not settle until someone started buying, and that would not happen until someone knew what the debt was worth.

As Indian commentator Satyajit Das comments, an informed analysis of the structured credit markets shows that, far from reducing risk, it has increased it – a nicely post-modern contradiction. He says that the maze of international finance is now almost beyond understanding. It is fast becoming a hall of mirrors, a maze of inter-connections reminiscent of the story The Lottery of Babylon by Argentinean post-modernist writer Jorge Luis Borges, in which infinite combinations emerge from infinite subdivision and “no decision is final; all branch into others”. As investor William Buffet comments, the range of derivatives contracts “is limited only by the imagination of man – or, sometimes, it seems, madmen.”

This hits at the very heart of capitalism. Even something as basic as ownership, the cornerstone of capitalism, can become confused in this self-referential maze. With securitisation, the lines of ownership become progressively more ambiguous as they become more complex. Is the debt owned by the bank that originally made the loan, is it owned by the intermediaries that package up the securitisation, or is it owned by the investors who purchase financial instruments like CDOs, which are essentially gambles on risk profiles? Hard to say. It became evident during the subprime crisis that the risks and exposures were spread so wide nobody knew where they started and ended.

Even the function of capital, to fund businesses, can be undermined in post-modern finance. A recent study by academics Henry Hu and Bernard Black concluded that, thanks to explosive growth in credit derivatives, debt-holders such as banks and hedge funds have often more to gain if companies fail than if they survive.

Answers From Different Eras

Sensing that something new and perilous is happening, most analysts are offering traditional answers to a very non-traditional problem. At the extreme end are the pre-modern gold bugs, urging a return to a gold standard and tangible money. More common are modernist assertions that financial practices will return to “normal”, by which is meant the practices of the second half of the twentieth century. But for this to be achieved, they claim, lots of pain will be required.

Couesbouc forecasts years of stagflation in America. The retired speculator George Soros described today’s American crisis as “the culmination of a super-boom that has lasted for more than 60 years”. Jim Grant, the publisher of Grant’s Interest Rate Observer believes that an American recession in the current circumstances could bring “an end to the Bretton Woods system, Mark II”, the financial order created when the gold standard was removed in 1972. The biggest of the world’s bond market investors, Bill Gross, the founder of Pimco, has said that “economic growth will be below zero or mildly above it for a long time, and nothing like what we’ve grown used to in the past 10 to 15 years.”

These comments hint at an underlying awareness that the modern era is over and that the current crisis is new. But they are really addressing the wrong problem. The problem is in their own models, the traditional methods for analysing markets. A difficulty with any arithmetic modelling of economic behaviour – such as the inter-relationship between interest rates and inflation – is that it can never include the human awareness of those rules. That is why most economic forecasts don’t work; because market participants know what is supposed to happen and so do something else instead in the hope of making money. Markets are not an unconscious machine whose operations can be mathematically modelled. They are made up of self conscious people acting to maximise their wealth, often by exploiting the mathematical models. Economic truisms are just an opening gambit for traders.

In post-modern, “de-regulated” financial markets the manipulation of the models is intense, often by highly trained mathematicians. None of that manipulation can be included in the models themselves.

Post-modernist finance challenges policy makers and regulators to put human beings at the centre of what happens in the monetary system, not let human behaviour be reduced to mathematical formulae. Money is, after all, a social artifice with a social role. It is not a natural force, to be analysed using quasi-science. And one particular group of humans, bankers and financial traders, should be scrutinised to see how responsible they are, how much they contribute to the common good, how beneficial are their experiments with the very nature of money. At the moment, their activities are beginning to look like the use of economic weapons of mass destruction.

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Governments might have to start considering the unthinkable – re-regulating the financial markets so as to remove some of the endless regresses that are causing such an excessive volume of transactions, and a series of bubbles. Greenspan said in 1998, that there is “no credible way to envision most government financial regulation being other than oversight of process,” arguing that the complexity is such that the “conventional regulatory examination process will become progressively obsolescent.” This may be right, but in the light of the current crisis, it points to a need to update regulation, not its abandonment.

Establishing guidelines for the sound balance between primary finance and the meta-level of finance would make sense, for instance. A comparatively small tax on the global capital flows would do much to reduce the volume of derivatives trades, because profits are garnered from tiny margins (although who would apply the tax is problematic).
Above all, a dose of healthy scepticism about aggressive, pro-market ideologies is long overdue.