An Economy of Buccaneers and Fantasists
Weapons of mass financial destruction
by Gabrielle Kolko
Le Monde diplomatique
www.zmag.org, October 16, 2006
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 resources.
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
since 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
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
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
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 skeptical
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.
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 stir.
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 bankruptcy.
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,
(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 collapsing.
(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
(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
(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.