[OPE-L] An economy of buccaneers and fantasists

From: Rakesh Bhandari (bhandari@BERKELEY.EDU)
Date: Sun Oct 15 2006 - 00:54:22 EDT

Kolko's latest book includes a scathing criticism of Marx's Capital.

An economy of buccaneers and fantasists
Weapons of mass financial destruction
Last month a major US hedge fund, Amaranth Advisors, lost more than half
its assets in a week, speculating on natural gas prices. The company
proved correct the chief worry of such major financial institutions as the
World Bank and the International Monetary Fund: that financial reality is
now out of control.

By Gabriel Kolko

GLOBAL financial structure is far less transparent now than it has ever
been. A few decades ago daily payments for foreign exchange transactions
were roughly equivalent to the capital stock of a major United States
bank; today they exceed the combined capital of the top 100 US banks.
Financial adventurers constantly create new products that defy nation
states and international banks. This May the International Monetary Fund’s
(IMF) managing director, Rodrigo de Rato, deplored these new risks, which
the weakness of the US dollar and the US’s mounting trade deficits have
greatly magnified.

His fears reflect the fact that the IMF has been in both structural and
intellectual crisis. Structurally, its outstanding credit and loans have
declined sharply since 2003, from over $70bn to a little over $20bn,
leaving it with far less leverage over the economic policies of developing
nations, and a smaller income than its expensive operations require. The
IMF admits it has been “quantitatively marginalised” (1). Many of its
problems are due to the doubling since 2003 of world prices for all the
commodities (oil, copper, silver, zinc, nickel, etc) which are
traditionally exported by developing nations. So developing nations have
been able to bring forward repayment of their debts, further reducing IMF

Higher prices for raw materials are likely to continue because rapid
economic growth in China, India and elsewhere has created burgeoning
demand that did not exist before, when the balance of trade systematic-
ally favoured rich nations. The US has seen its net foreign asset position
fall, whereas Japan, emerging Asia and oil-exporting nations have become
far more powerful over the past decade and have become creditors to the
US. As US deficits mount, with imports far greater than exports, the value
of the dollar has declined, falling by 28% against the euro between 2001
and 2005.

The IMF and World Bank were also severely chastened by the 1997-2000
financial meltdowns in East Asia, Russia and elsewhere. Many of their
leaders lost faith in the anarchic premises, inherited from classical
laissez-faire economic thought, which had guided their policy advice until
then. Intellectually both institutions are now far more defensive and
concede that the premises that led to their creation in 1944 are hardly
relevant to the way the real world now operates. Our “knowledge of
economic growth is extremely incomplete,” many in the IMF now admit, and
it now needs “more humility”. The IMF concedes that the international
economy has been transformed dramatically si nce then and, as Stephen
Roach of bankers Morgan Stanley has warned, the world “has done little to
prepare itself for what could well be the next crisis” (2).

The nature of the global financial system has changed radically in ways
that have nothing to do with virtuous national economic policies that
follow IMF advice. The investment managers of private equity funds and
major banks have displaced national banks and international bodies such as
the IMF. In many investment banks, buccaneering traders have taken over
from more cautious and traditional bankers and owners. Buying and selling
shares, bonds and derivatives now generate higher profits, and taking far
greater risks is now the rule among what was once a fairly conservative
branch of finance.

Profits, real or not
Such traders are rewarded on the basis of profits, fictitious or real, and
routinely bet with house money. Low interest rates, and banks eager to
lend money to hedge funds and firms that arrange mergers and acquisitions,
have given such traders and others in the US, Japan and elsewhere, a
mandate to play financial games, including making dubious mergers that
would once have been deemed foolhardy. In some cases, leveraged
recapitalisations allow the traders to pay themselves enormous fees and
dividends immediately, by adding to a company’s debt burden. What happens
later is someone else’s problem.

Since the beginning of 2006 investment banks have vastly expanded their
loans to leveraged buy-outs, pushing commercial banks out of a market they
once dominated. To win a greater share of the market, they are making
riskier deals and increasing the likelihood of defaults among highly
leveraged firms — “living dangerously” as the head of Standard & Poor’s
bank loan ratings section put it. “Observers are predicting a sharp
increase in defaults among highly leveraged companies,” the Financial
Times noted in July (3).

But there are fewer legal clauses to protect investors, so lenders are
less likely than ever to compel mismanaged firms to default. Hedge funds,
aware that their bets are more and more risky, are making it much more
difficult to withdraw the money with which they play. Traders have
“reintermediated” themselves between traditional borrowers (national and
individual) and markets, further deregulating the world financial
structure and making it far more susceptible to crises. They seek to
generate high investment returns and take mounting risks to do so.

This March the IMF released Garry J Schinasi’s well-documented book
Safeguarding Financial Stability (4), giving it unusual prominence. The
book is alarming, and reveals and documents the IMF’s deep anxieties in
disturbing detail. Deregulation and liberalisation, which the IMF and
proponents of the Washington consensus (5) have advocated for decades,
have become a nightmare: they have created “tremendous private and social
benefits” (6) but also hold “the potential for fragility, instability,
systemic risk, and adverse economic consequences”.

Schinasi concludes that the irrational development of global finance,
combined with deregulation and liberalisation, has “created scope for
financial innovation and enhanced the mobility of risks”. Schinasi and the
IMF advocate a radical new framework to monitor and prevent the problems
that are now enabled to emerge, but any success “may have as much to do
with good luck” as with policy design and market surveillance. Leaving the
future to luck is not at all what economics originally promised.

Even more alarming is a study, also publicised by the IMF and produced at
the same time by establishment specialists, analysing the problems that
deregulation of the world financial structure has created. The authors
believe that deregulation has caused “national financial systems [to]
become increasingly vulnerable to increased systemic risk and to a growing
number of financial crises” (7). The IMF shares the growing consensus
among conservative banking experts that the world financial structure has
now become far more precarious.

As the financial meltdown of Argentina in 1998 proved, countries that do
not succumb to IMF and banker pressures can play on divisions within the
IMF membership to avoid many, though not all, foreign demands. About
$140bn in sovereign bonds to private creditors and the IMF were at stake
in Argentina, terminating in 2001 with the largest national default in
history. Banks in the 1990s had been eager to lend Argentina money and
they ultimately paid for their eagerness.

When prices soared
Since then, however, commodity prices have soared. The growth rate of
developing nations in 2004 and 2005 was more than double that of
high-income nations. As early as 2003 developing countries were already
the source of 37% of the foreign direct investment in other developing
nations. China accounts for much of this growth, which means that the IMF
and rich bankers of New York, Tokyo and London have far less leverage than
before. After the financial crises in the developing world in the late
1990s, bankers resolved that they would be more cautious in the future,
yet their current exposure to emerging market stocks and bonds is as great
as ever because of far higher yields in Zambia or the Philippines, and
excess cash. “The love affair is back on,” said a bank trader (8).

Growing complexity in the world economy and the endless negotiations of
the World Trade Organisation have failed to overcome the subsidies and
protectionism that have thwarted a global free trade agreement and an end
to the threat of trade wars. The potential for greater instability and
danger for the rich now exists in the entire world economy.

The emerging global financial problem is proving inextricably tangled,
with a fast-rising US fiscal and trade deficit. Since George Bush took
presidential office in the US in 2001 he has added more than $3 trillion
to federal borrowing limits, which are now almost $9 trillion. As long as
there is a continued devaluation of the US dollar, banks and financiers
will seek to guard their money and risky financial adventures will appear
worthwhile. This is the context, but Washington had advocated greater
financial deregulation long before the dollar weakened.

There are now at least 10,000 hedge funds, of which 8,000 are registered
in the Cayman Islands. However, the 400 funds with $1bn or more under
management do 80% of the business. They cannot be regulated. They have
over $1.5 trillion in assets and the daily global derivatives turnover is
almost $6 trillion (equal to half US gross domestic product). With the
economic climate euphoric over the past five years, most funds have won,
although some have lost. In the year ending this August, nearly 1,900 were
created and 575 were liquidated. Standard & Poor would like to rank their
credit-worthiness, but has yet to do so: bigger funds claim to use
computer models to make trades, and three of the 10 biggest claim they
make purely quantitative decisions.

One of the most serious post-1945 financial threats to the global economy,
the failure of the Long-Term Capital Management (LTCM) hedge fund in 1998,
involved a firm renowned for its mathematical trading techniques devised
by two Nobel prize laureates, Myron Scholes and Robert Merton (9). The
combined efforts of Washington and Wall Street prevented a disaster with
LTCM, but the hedge funds are now much too big to be saved easily.

In effect, hedge funds, which are extremely competitive, gamble and take
great chances; they are attracted to credit derivatives (10) and many
similar devices invented with the promise of making money. The credit
derivative market was almost nonexistent in 2001, grew slowly until 2004
and then went into the stratosphere, reaching $26 trillion this June. Many
other financial instruments are now being invented, and markets for credit
derivative futures, credit default swaps (11) and binary options are in
the offing.

What are credit derivatives? The Financial Times’s chief capital markets
writer, Gillian Tett, tried to find out, but failed. The legend goes that
around a decade ago some bankers from JP Morgan were in Boca Raton,
Florida, drinking and throwing each other into the swimming pool when they
came up with the notion of a new financial instrument that was too complex
to be copied easily (since financial ideas cannot be copyrighted) and sure
to make them money.

Tett was critical of the potential of credit derivatives for causing a
chain reaction of losses which could engulf the hedge funds that have
jumped into this market. Bankers have become “ultra-creative in their
efforts to slice, dice and redistribute risk, at this time of easy
liquidity,” she concluded. The Financial Times has in recent months run a
series on financial wizardry which has been frankly sceptical of the means
and ends of these innovations (12).

One of the gurus of finance, Avinash Persaud, concluded that low interest
rates have led investors to use borrowed money to play the markets, and “a
painful deleveraging is as inevitable as night follows day . . . the only
question is its timing.” There is no way that hedge funds, which have
become intricate in their arrangements to seek safety, can avoid a
reckoning and they will be “forced to sell their most liquid investments”.
“I will not bet on that happy outcome,” Gillian Tett concluded in her
survey of belated attempts to redeem the hedge funds from their own
follies (13).

Warren Buffett, Forbes-listed as the second richest person in the world,
has called credit derivatives “financial weapons of mass destruction”.
Nominally they are insurance against defaults, but they encourage greater
gambles and credit expansion, which are moral hazards. Enron (14) used
them extensively; they were a secret of Enron’s success and also of its
eventual bankruptcy with $100bn losses. They are not monitored in any real
sense, and experts have called them “maddeningly opaque”. Many innovative
financial products, according to a finance director, only “exist in
cyberspace”, often as tax dodges for the ultra-rich (15).

Banks do not understand the chain of exposure and who owns what: senior
financial regulators and bankers now admit this. Hedge funds claim to be
honest, but those who guide them are compensated for the profits they
make, which means taking risks. There are thousands of hedge funds and
many collect inside information. This is technically illegal but it
happens anyway.

Growing danger
There is now a consensus that all this has created growing financial
dangers. We can put aside the persistence of unbalanced national budgets
based on spending increases or tax cuts for the wealthy, and the world’s
volatile stock and commodity markets which caused hedge funds to show far
lower returns in May 2006 than they have the past year. Hedge funds still
make plenty of profit but they are increasingly dangerous.

It is too soon to estimate the ultimate impact of the recent and widely
publicised loss by Amaranth Advisors (16) hedge fund of more than $6bn,
representing over 60% of its assets, within a single week. Amaranth
collaborated closely with Morgan Stanley, Goldman Sachs and other
important investment houses, which explains why its losses caused such a

The overall problems are structural, and include the greatly varying
ratios between corporate debt loads and core earnings, which have grown
substantially from four to six times over the past year because there are
fewer legal clauses to protect investors from loss. They also keep
companies from going bankrupt when they should. As long as interest rates
have been low, leveraged loans (17) have been the solution. Because of
hedge funds and other financial instruments, there is now a market for
incompetent and debt-ridden firms. When the Ford Motor Company announced
last month that it was losing over $7bn annually, its bonds actually shot
up 20%. The rules once associated with capitalism, such as probity and
profit, no longer hold.

The problems inherent in speed and complexity are diverse and can be
almost surreal. Credit derivatives are precarious enough, but this May the
International Swaps and Derivatives Association revealed that one in every
five deals, many of them involving billions of dollars, had major errors.
As the volume of trade increased, so did the errors. They doubled after
2004. More than 90% of all deals in the US were not properly recorded, but
put down only on paper and often just scraps at that.

In 2004 Alan Greenspan, then chairman of the US Federal Reserve, admitted
to being “frankly shocked” by this situation. Efforts to remedy the mess
only began this June and are far from resolving a major and accumulated
problem involving stupendous sums. More importantly, deregulation and
financial innovation have led to forms of crucial data that cannot be
collected and quantified, leaving both bankers and governments in the dark
about reality. We may or may not live in a new era of finance, but we
certainly are flying blindfolded.

On 24 April Stephen Roach, Morgan Stanley’s chief economist, wrote that a
major financial crisis seemed imminent and that the global institutions
that could forestall it, including the IMF, the World Bank and other
mechanisms of the international financial architecture, were utterly
inadequate (18). Hong Kong’s chief secretary deplored the hedge funds’
risks and dangers in June, and at the same time the IMF’s iconoclastic
chief economist, Raghuram Rajan, warned that funds’ compensation
structures encouraged those in charge to take risks, endangering the whole
financial system. Soon after Roach was even more pessimistic: “a certain
sense of anarchy” dominated academic and political communities “unable to
explain the way the new world is working” (19). In its place, mystery
prevailed. By last month the IMF predicted that the risk of a severe
slowdown in the global economy was greater than at any time since 2001,
mainly because of the sharp decline in housing markets in the US and much
of western Europe; it also included the decline in US labour’s real income
and insufficient consumer purchasing power (20). Even if the current level
of prosperity endures through next year, and all these people are proved
wrong, the transformation of the global financial system will sooner or
later lead to dire results.

Reality is out of control
Reality is out of control. The entire global financial structure is
becoming uncontrollable in crucial ways that its nominal leaders never
expected, and instability is its hallmark. The scope and operation of
international financial markets, their “architecture”, as establishment
experts describe it, has evolved haphazardly and its regulation is
inefficient — indeed, almost nonexistent (21).

Financial deregulation has produced a monster, and resolving the many
problems that have emerged is scarcely possible for those who deplore
controls on making money. The Bank for International Settlement’s (BIS)
annual report, released in June, discusses these problems and the triumph
of predatory economic behaviour and trends “difficult to rationalise”. The
sharks have outflanked more conservative bankers. “Given the complexity of
the situation and the limits of our knowledge, it is extremely difficult
to predict how all this might unfold” (22). The BIS does not want its
fears to cause panic, and circumstances compel it to remain on the side of
those who are not alarmist. But it now concedes that a big crash in the
markets is a possibility, and sees “several market-specific reasons for a
concern about a degree of disorder”.

We are “currently not in a situation” where a meltdown is likely to occur,
but “expecting the best but planning for the worst” is still prudent. The
BIS admits that, for a decade, global economic trends and financial
imbalances have created worsening dangers, and “understanding how we got
to where we are is crucial in choosing policies to reduce current risks”
(23). The BIS is very worried.

Given such profound and widespread pessimism, vultures from investment
houses and banks have begun to position themselves to profit from imminent
business distress, a crisis they see as a matter of timing rather than
principle. There is now a growing consensus among financial analysts that
defaults will increase substantially in the near future. Because there is
money to be made in the field, there is now great demand on Wall Street
for experts in distressed debt and in restructuring companies in or near

More about Gabriel Kolko.
Original text in English
* Gabriel Kolko is a historian and author of ‘The Age of War’ (Lynne
Rienner, Boulder, Colorado, 2006) and ‘After Socialism: Reconstructing
Critical Social Thought’ (Routledge, London, 2006)

(1) IMF Survey, New York, 29 May 2006; IMF in Focus, New York, September
2006. (.pdf files) See also : IMF Survey index 2006 page.

(2) Roberto Zagha, “Rethinking Growth”, Finance & Development, Washington
DC, March 2006; Stephen Roach, Global Economic Forum, Morgan Stanley, New
York, 16 June 2006.

(3) Financial Times, London, 17 July and 14 August 2006.

(4) Garry J Schinasi, Safeguarding Financial Stability: Theory and
Practice, IMF, New York, 2006. (.pdf file).

(5) The term was coined by the economist John Williamson in 1989 and
summarises the recommendations made to states, including tax reductions,
free markets, privatisation and financial deregulation. To qualify for IMF
loans, governments must implement such measures.

(6) This and following quotes are from Schinasi, op cit.

(7) Kern Alexander, Rahul Dhumale and John Eatwell, Global Governance of
Financial Systems: The International Regulation of Systemic Risk, Oxford
University Press, 2005.

(8) Financial Times, 27 July 2006.

(9) With assets of only $5bn, LTCM found itself owing some $100bn. The
Federal Reserve and Wall Street paid out $3.6bn to prevent the system from

(10) As with all derivatives, operators bet on foreseeable risks but in
this case it was credit (bonds, debts, etc) that was exchanged.

(11) The seller undertakes, subject to payment of a surcharge, to
compensate the customer in the event of a default on payment or simply a
deterioration in the quality of its debtors.

(12) Gillian Tett, “The dream machine, invention of credit derivatives”,
Financial Times Magazine, London, 24-25 March 2006; Financial Times, 10
and 19 July 2006, 14, 24 and 29 August 2006.

(13) Financial Times, 23 and 24-25 June 2006.

(14) See Tom Frank, “Enron: Elvis lives”, Le Monde diplomatique, English
language edition, February 2002.

(15) Financial Times, 17 July; 31 May; 8 June 2006.

(16) Amaranth, based in Connecticut, incurred huge losses speculating on
the price of natural gas. Brian Hunter, the energy trader said to be
largely responsible for the gas losses, was later said to have left the
company; at the same time, the company’s chief executive officer, Nick
Maounis, told investors that it planned to get out of energy trading, in
which it had previously invested more than half its capital.

(17) With these loans it is possible to buy a company with a very small
capital outlay and loans at rates lower than the expected rate of profit.

(18) Global Economic Forum, Morgan Stanley, 24 April 2006.

(19) Ibid, 23 June and 5 September 2006.

(20) Financial Times, 6 September 2006.

(21) Alexander, Dhumale and Eatwell, op cit.

(22) 76th Annual Report, Bank for International Settlements, Basel, 26
June 2006.

(23) Ibid..

English language editorial director: Wendy Kristianasen - all rights
reserved © 1997-2006 Le Monde diplomatique.

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