UNITE! Info #305en: Will the world economy crash? (2) - An article in the
Boston Globe
[Posted: 28.01.2008]
Note: The "UNITE! (etc) Info" posting series (1995-) advocates the
political
line of Marx, Lenin and Mao Zedong. For all items, see
www.rolf-martens.com.
INTRO NOTE:
For a few factors which concern the world economy and which I know about
since
I know something of the theory of Marxism, see item (1) in this
sub-series,
Info #275en, of 15.03.2007. Many other things concerning that economy
remain as
much a mystery to me as probably to most or perhaps even all others.
In this Info I'm simply reproducing in full an article which appeared in
the
Boston Globe, the USA, yesterday, entitled "The black box economy". It
seems to
me to be im****tant. Its author, Stephen Mihm, the newspaper says, is an
assistant professor of American history at the University of Georgia and
the
author of the book "A Nation of Counterfeiters".
[http://www.boston.com/bostonglobe/ideas/articles/2008/01/27/the_black_box_econ
omy/]
[QUOTE:]
T H E B L A C K B O X E C O N O M Y
By Stephen Mihm
January 27, 2008
Behind the recent bad news lurks a much deeper concern: The world economy
is
now being driven by a vast, secretive web of investments that might be out
of
anyone's control.
THE PAST YEAR has been a harrowing one for the world's financial markets,
shaken by subprime crises, credit crunches, and other ills. Things have
only
gotten stranger in the past week, with stock prices swinging wildly in
every
major market - drastically down, then back up.
Last week the Federal Reserve announced the biggest cut in overnight
lending
rates in more than two decades. Congress, not to be outdone, is slapping
together a massive deficit spending package aimed at giving the economy an
emergency booster shot.
Despite the anxiety, nobody is stockpiling canned goods just yet. The
prevailing assumption in today's economy is that recessions and bear
markets
come and go, and that things will work out in the end, much as they have
since
the Great Depression. That's because there's a collective confidence that
the
market is strong enough to correct itself, and that experts in charge of
the
financial system will understand how to mount a vigorous defense.
Should we be so confident this time? A handful of financial theorists and
thinkers are now saying we shouldn't. The drumbeat of bad news over the
past
year, they say, is only a symptom of something new and unsettling - a
deeper
change in the financial system that may leave regulators, and even
Congress,
powerless when they try to wield their usual tools.
That something is the immense shadow economy of novel and poorly
understood
financial instruments created by hedge funds and investment banks over the
past
decade - a web of extraordinarily complex securities and wagers that has
made
the world's financial system so opaque and entangled that even many
experts
confess that they no longer understand how it works.
Unlike the building blocks of the conventional economy - factories and
firms,
widgets and workers, stocks and bonds - these new financial arrangements
are
difficult to value, much less analyze. The money caught up in this web is
now
many times larger than the world's gross domestic product, and much of it
exists outside the purview of regulators.
Some of these new-generation investments have been in the news, such as
the
securities implicated in the mortgage crisis that is still shaking the
housing
market. Others, involving auto loans, credit card debt, and cor****ate
debt, are
lurking in the shadows.
The scale and complexity of these new investments means that they don't
just
defy traditional economic rules, they may change the rules. So much of the
world's capital is now tied up in this shadow economy that the traditional
tools for fixing an economic downturn - moves that have averted serious
disasters in the recent past - may not work as expected.
In tell-all books, financial blogs, and small-circulation newsletters, a
handful of insiders have begun to sound the alarm, warning that
governments and
top bankers may simply no longer understand the financial system well
enough to
do anything about it.
"Central banks have only two tools," says Satyajit Das, author of
"Traders,
Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives,"
who
has emerged as a voice of concern. "They can cut interest rates or they
can
regulate banks. But these are very old-fa****oned tools, and are completely
inadequate to the problems now confronting them."
Since the last financial crisis that genuinely threatened the fabric of
our
society, the Great Depression, the United States has built a system of
regulatory checks and balances that has, for the most part, worked. The
system
has worked because the new regulations enforced some semblance of
transparency.
Companies abide by an extensive set of rules and file information on their
profits, losses, and assets.
Obviously, there are limits to transparency: Without withholding some
information from public view, it would be hard for companies to take
advantage
of op****tunities in the marketplace. But a modicum of transparency can go
a
long way, enabling both regulators and investors to make informed
decisions.
The advantages of the system are many; the costs of even a single case of
nontransparency, as with Enron, can be high.
But when the mortgage crisis broke last summer, it opened a window on
something
else: The existence of a huge wilderness of investments in the financial
sector
that are nearly impossible to track or measure, and which operate out of
the
view of both investors and regulators. It emerged that investment banks,
hedge
funds, and other financial players had issued, bought, and sold hundreds
of
billions of dollars' worth of esoteric securities backed in part by other
securities, which in turn were backed by payments on high-risk mortgages.
When borrowers began defaulting on their loans, two things happened. One,
banks, pension funds, and other institutional investors began revealing
that
they owned huge quantities of these unusual new securities, called
collateralized debt obligations, or CDOs. The banks began writing them
off,
causing the massive losses that have buffeted the country's best-known
financial companies. And two, without a market for these securities,
brokers
stopped wanting to issue risky mortgages to new home buyers. Home values
began
their plunge.
In other words, a staggeringly complex financial instrument that most
Americans
had never heard of, and which many financial writers still don't fully
understand, became in a matter of months the most im****tant influence on
home
values in America. That's not how the economy is supposed to work - or at
least
that's not what they teach students in Economics 101.
The reason this had been happening totally out of sight is not difficult
to
understand. Banks of all stripes chafe against the restraints that federal
and
state regulators place on their ability to make money. By cleverly
exploiting
regulatory loopholes, investment banks created new types of high-risk
investments that did not appear on their balance sheets. Safe from the
prying
eyes of regulators, they allowed banks to dodge the requirement that they
keep
a certain amount of money in reserve. These reserves are a crucial safety
net,
but also began to seem like a drag to financiers, money that was just
sitting
on the sidelines.
"A lot of financial innovation is designed to get around regulation," says
Richard Sylla, professor of economics and financial history at NYU's Stern
School of Business. "The goal is to make more money, and you can make more
money if you don't have to keep capital to back up your investments."
The hiding places for these financial instruments are called conduits.
They go
by various names - the SIV, or structured investment vehicle, is one
that's
been in the news a great deal the past few months. These conduits and the
various esoteric investments they harbor constitute what Bill Gross,
manager of
the world's largest bond mutual fund, called a "Frankensteinian levered
body of
shadow banks" in his January newsletter.
"Our modern shadow banking system," Gross writes, "craftily dodges the
reserve
requirements of traditional institutions and promotes a chain letter,
pyramid
scheme of leverage, based in many cases on no reserve cu****on whatsoever."
The mortgage-driven securities that have been making headlines are but the
tip
of a much larger iceberg. Far larger categories of investment have sprung
up,
with just as much secrecy, and even less clarity into who holds them and
how
much they are truly worth.
Many of these began as conventional instruments of finance. For instance,
derivatives - the broad category of investments whose value is somehow
based on
other assets, whether a stock, commodity, debt, or currency - have been
traded
for more than a century as a form of insurance, helping stabilize
otherwise
volatile markets.
But today, increasingly, a new generation of derivatives doesn't trade on
markets at all. These so-called over-the-counter derivatives are highly
customized agreements struck in private between two parties. No one else
necessarily knows about such investments because they exist off the books,
and
don't show up in the re****ts or balance sheets of the parties who signed
them.
As the derivatives business has grown more complex, it has also ballooned
in
scale. Broadly speaking, Das - author of a leading textbook on derivatives
and
complex securities - estimates that investors worldwide hold more than
$500
trillion worth of derivatives. This number now dwarfs the global GDP,
which
tops out around $60 trillion.
Essentially unregulated and all but invisible, over-the-counter
derivatives
comprise a huge web of bets, touching every sector of the world economy,
that
entangles a massive amount of money. If they start to look shaky - or if
investors need to start selling them to cover other losses - that value
could
vanish, with catastrophic results to the owner and unpredictable effects
on
financial markets.
Derivatives can ripple through the market and link players that might not
otherwise be connected. With some types of new investments, that fusion
takes
place within the security itself.
For instance, some financial instruments are built of two or more
different
types of assets, linking together sectors of the economy that aren't
supposed
to move in tandem. In the name of transferring risk - and in the interest
of
creating an appealing new product to sell to aggressive investors seeking
higher returns - a bank could create a CDO, for instance, that packaged
subprime mortgages together with cor****ate bonds. An economist would
expect
those to move independently, but thanks to a large - and unseen -
investment in
such a linked package, problems with one could drive down the other. A bad
apple can ruin an entire barrel of fruit.
Again, it's not as though anyone necessarily knows the composition of
these
structured securities. Nor do they know who has invested in them, thanks
to the
fact that they have not, until recently, counted as conventional assets
subject
to the normal rules of accounting. And because they don't trade on open
markets, their values are essentially guesses, calculated by computer
algorithms.
Das disparages much of this as the product of bankers creating "complexity
for
the sake of complexity," trying to wow their clients by inventing more
sophisticated-seeming investments. "Financial innovation is a magical
catch
phrase," he explains. "It's very sophisticated and chi-chi."
"Investment bankers want to make them more complex, so that they won't be
copied, and so that their clients won't understand them," he says. "When
they
ask whether they're paying the right amount, they won't know."
But when reality comes home to roost, things can get ugly pretty quickly:
If an
investor is forced to sell a CDO, the onetime price realized on the open
market
may bear no relation****p to the theoretical value generated by a computer
formula. That means that everyone holding CDOs can no longer sleep well at
night: the same thing can happen to them.
These risks are magnified, as they were during the stock bubble of the
1920s,
by the fact that many of these assets are owned by investors who borrowed
money
to make the investments in the first place. When a market shock like the
subprime crisis hits, it can send tremors through the system with
incredible
speed.
If the contagion spreads, the conventional wisdom holds that the Federal
Reserve and other central banks around the world can step into the breach
caused when consumers and investors start to lose their confidence. But
what
happens when all these complicated financial arrangements and instruments
start
to unravel? The market for one product alone - the credit default swap, or
CDS
- dwarfs this country's economy. The Fed has an uphill battle, made harder
by
the fact that it is grappling, to a large extent, with unseen forces.
In theory, additional regulation may help with this. The Financial
Accounting
Standards Board, which establishes cor****ate accounting procedures and
guidelines, took a first step in that direction this past November,
ordering
investment banks and anyone else holding complicated securities to assign
market values to so-called Level 3 assets - a fancy name for assets for
which
there is no prevailing market price. This meant assigning a market value
to all
those CDOs.
Banks promptly began writing down tens of billions of dollars of assets,
and
their investors are still trying to sort through the results. It's still
too
early to tell whether or not the effort will work, or whether the "market
prices" that get re****ted are anything more than figments of in-house
accountants' imaginations. For his part, Das is skeptical. "It will help
that
people will know the poison they're drinking," he says. "Whether it will
help
stabilize the system is another question."
It would be ideal if the financial markets became a bit less opaque and
intelligible before that happens. That would be the job of regulators, but
Das
isn't sure that regulators have the intellectual horsepower to figure out
what
they need to do. "If you're bright and you can make $5 million a year on
Wall
Street," he asks, "why would you settle for making 50K as a regulator?"
And in any case, transparency isn't really what the denizens of Wall
Street
want, Das observes. "The regulators keep espousing things like clarity and
transparency, but it's in the investment bankers' interest to keep things
opaque." Das pauses for a moment.
"It's like a butcher. He doesn't want the buyer to know what goes into
making
the sausage." He chuckles, noting that it's the same with financiers.
"That's
what they're all about and always have been."
Stephen Mihm is an assistant professor of American history at the
University of
Georgia and the author of "A Nation of Counterfeiters."
© Copyright 2008 Globe Newspaper Company.
[END OF QUOTE]
_____________________
Message posted by:
Rolf Martens
Malmö, Sweden
Phone and fax:
+46 - 40 - 124832;
rolf.martens@[EMAIL PROTECTED]
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