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. “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.

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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.

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?

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