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.
Author of “America’s Suicidal Statecraft”