From: glevy@PRATT.EDU
Date: Sat Aug 19 2006 - 13:32:15 EDT
Here's yet another prediction ... in this case, from unlikely and
unusual sources. Other reasons are suggested, though.
In solidarity, Jerry
=======================================================
Bankers Fear World Economic Meltdown, by Gabriel Kolko
Counterpunch, July 26, 2006 (www.counterpunch.com)
There has been a profound and fundamental change in the world
economy over the past decade. The very triumph of financial
liberalization and deregulation, one of the keystones of the
"Washington consensus" that the U.S. government, International
Monetary Fund (IMF), and World Bank have persistently and
successfully attempted over the past decades to implement, have also
produced a deepening crisis that its advocates scarcely expected.
The global financial structure is today far less transparent than
ever. There are many fewer reporting demands imposed on those who
operate in it. Financial adventurers are constantly creating new
"products" that defy both nation-states and international banks.
The IMF's managing director, Rodrigo de Rato, at the end of May
2006 deplored these new risks risks that the weakness of the U.S.
dollar and its mounting trade deficits have magnified greatly.
De Rato's fears reflect the fact that the IMF has been undergoing
both structural and intellectual crises. Structurally, its
outstanding credit and loans have declined dramatically since 2003,
from over $70 billion to a little over $20 billion today, doubling
its available resources and leaving it with far less leverage over
the economic policies of developing nations and even a smaller
income than its expensive operations require. It is now in deficit.
A large part of its problems is due to the doubling in world prices
for all commodities since 2003 especially petroleum, copper,
silver, zinc, nickel, and the like that the developing nations
traditionally export. While there will be fluctuations in this
upsurge, there is also reason to think it may endure because rapid
economic growth in China, India, and elsewhere has created a
burgeoning demand that did not exist before when the balance-of-
trade systematically favored the rich nations. The U.S.A. has seen
its net foreign asset position fall as Japan, emerging Asia, and oil-
exporting nations have become far more powerful over the past
decade, and they have increasingly become creditors to the U.S.A. As
the U.S. deficits mount with its imports being far greater than its
exports, the value of the dollar has been declining 28 per cent
against the euro from 2001 to 2005 alone. Even more, the IMF and
World Bank were severely chastened by the 1997-2000 financial
meltdowns in East Asia, Russia, and elsewhere, and many of its key
leaders lost faith in the anarchic premises, descended from
classical laissez-faire economic thought, which guided its policy
advice until then. "
{O]ur knowledge of economic growth is
extremely incomplete," many in the IMF now admit, and "more
humility" on its part is now warranted. The IMF claims that much
has been done to prevent the reoccurrence of another crisis similar
to that of 1997-98, but the international economy has changed
dramatically since then and, as Stephen Roach of MorganStanley has
warned, the world "has done little to prepare itself for what could
well be the next crisis."
The whole nature of the global financial system has changed
radically in ways that have nothing whatsoever to do with
"virtuous" national economic policies that follow IMF advice
ways the IMF cannot control. The investment managers of private
equity funds and major banks have displaced national banks and
international bodies such as the IMF, moving well beyond the
existing regulatory structures. In many investment banks, the
traders have taken over from traditional bankers because buying and
selling shares, bonds, derivatives and the like now generate the
greater profits, and taking more and higher risks is now the rule
among what was once a fairly conservative branch of finance. They
often bet with house money. Low-interest rates have given them and
other players throughout the world a mandate to do new things,
including a spate of dubious mergers that were once deemed
foolhardy. There also fewer legal clauses to protect investors, so
that lenders are less likely than ever to compel mismanaged firms to
default. Aware that their bets are increasingly risky, hedge funds
are making it much more difficult to withdraw money they play with.
Traders have "re-intermediated" themselves between the traditional
borrowers both national and individual and markets, deregulating
the world financial structure and making it far more unpredictable
and susceptible of crises. They seek to generate high investment
returns which is the key to their compensation and they take
mounting risks to do so.
In March of this year the IMF released Garry J. Schinasi's book,
Safeguarding Financial Stability, giving it unusual prominence then
and thereafter. Schinasi's book is essentially alarmist, and it
both reveals and documents in great and disturbing detail the IMF's
deep anxieties. Essentially, "deregulation and liberalization,"
which the IMF and proponents of the "Washington consensus"
advocated for decades, has become a nightmare. It has created
"tremendous private and social benefits" but it also holds "the
potential (although not necessarily a high likelihood) for
fragility, instability, systemic risk, and adverse economic
consequences." Schinasi's superbly documented book confirms his
conclusion that the irrational development of global finance,
combined with deregulation and liberalization, 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 now able to emerge, but success "may have as
much to do with good luck" as policy design and market
surveillance. Leaving the future to luck is not what economics
originally promised. The IMF is desperate, and it is not alone. As
the Argentina financial meltdown proved, countries that do not
succumb to IMF and banker pressures can play on divisions within the
IMF membership - particularly the U.S. - bankers and others to
avoid many, although scarcely all, foreign demands. About $140
billion in sovereign bonds to private creditors and the IMF were at
stake, terminating at the end of 2001 as the largest national
default in history. Banks in the 1990s were eager to loan Argentina
money, and they ultimately paid for it. Since then, however,
commodity prices have soared, the growth rate of developing nations
in 2004 and 2005 was over double that of high income nations - a
pattern projected to continue through 2008 - and as early as 2003
developing countries were already the source of 37 per cent of the
foreign direct investment in other developing nations. China
accounts for a great part of this growth, but it also means that the
IMF and rich bankers of New York, Tokyo, and London have much less
leverage than ever.
At the same time, the far greater demand of hedge funds and other
investors for risky loans, combined with low-interest rates that
allows hedge funds to use borrowed money to make increasingly
precarious bets, has also led to much higher debt levels as
borrowers embark on mergers and other adventures that would
otherwise be impossible.
Growing complexity is the order of the world economy that has
emerged in the past decade, and the endless negotiations of the
World Trade Organization have failed to overcome the subsidies and
protectionism that have thwarted a global free trade agreement and
end of threats of trade wars. Combined, the potential for much
greater instability and greater dangers for the rich now exists
in the entire world economy.
High-speed Global Economics
The global financial problem that is emerging is tied into an
American fiscal and trade deficit that is rising quickly. Since Bush
entered office in 2001 he has added over $3 trillion to federal
borrowing limits, which are now almost $9 trillion. So long as there
is a continued devaluation of the U.S. dollar, banks and financiers
will seek to protect their money and risky financial adventures will
appear increasingly worthwhile. This is the context, but Washington
advocated greater financial liberalization long before the dollar
weakened. This conjunction of factors has created infinitely greater
risks than the proponents of the "Washington consensus" ever
believed possible.
There are now many hedge funds, with which we are familiar, but they
now deal in credit derivatives and numerous other financial
instruments that have been invented since then, and markets for
credit derivative futures are in the offing. The credit derivative
market was almost nonexistent in 2001, grew fairly slowly until 2004
and then went into the stratosphere, reaching $17.3 trillion by the
end of 2005.
What are credit derivatives? The Financial Times' chief capital
markets writer, Gillian Tett, tried to find out but failed. About
ten years ago some J.P. Morgan bankers were in Boca Raton, Florida,
drinking, throwing each other into the swimming pool, and the like,
and they came up with a notion of a new financial instrument that
was too complex to be easily copied (financial ideas cannot be
copyrighted) and which was sure to make them money. But Tett was
highly critical of its potential for causing a chain reaction of
losses that will engulf the hedge funds that have leaped into this
market. Warren Buffett, second richest man in the world, who knows
the financial game as well as anyone, has called credit derivatives
"financial weapons of mass destruction." Nominally insurance
against defaults, they encourage far greater gambles and credit
expansion. Enron used them extensively, and it was one secret of
their success and eventual bankruptcy with $100 billion in losses.
They are not monitored in any real sense, and two experts called
them "maddeningly opaque." Many of these innovative financial
products, according to one finance director, "exist in cyberspace"
only and often are simply tax dodges for the ultra-rich. It is for
reasons such as these, and yet others such as split capital trusts,
collateralized debt obligations, and market credit default swaps
that are even more opaque, that the IMF and financial authorities
are so worried.
Banks simply do not understand the chain of exposure and who owns
what - senior financial regulators and bankers now admit this. The
Long-Term Capital Management hedge fund meltdown in 1998, which
involved only about $5 billion in equity, revealed this. The
financial structure is now infinitely more complex and far larger
the top 10 hedge funds alone in March 2006 had $157 billion in
assets. Hedge funds claim to be honest but those who guide them are
compensated for the profits they make, which means taking risks. But
there are thousands of hedge funds and many collect inside
information, which is technically illegal but it occurs anyway. The
system is fraught with dangers, starting with the compensation
structure, but it also assumes a constantly rising stock market and
much, much else. Many fund managers are incompetent. But the 26
leading hedge fund managers earned an average of $363 million each
in 2005; James Simons of Renaissance Technologies earned $1.5
billion.
There is now a consensus that all this, and much else, has created
growing dangers. We can put aside the persistence of imbalanced
budgets based on spending increases or tax cuts for the wealthy,
much less the world's volatile stock and commodity markets which
caused hedge funds this last May to show far lower returns than they
have in at least a year. It is anyone's guess which way the markets
will go, and some will gain while others lose. Hedge funds still
make lots of profits, and by the spring of 2006 they were worth
about $1.2 trillion worldwide, but they are increasingly dangerous.
More than half of them give preferential treatment to certain big
investors, and the U.S. Security and Exchange Commission has since
mid-June 2006 openly deplored the practice because the panic, if not
chaos, potential in such favoritism is now too obvious to ignore.
The practice is "a ticking time bomb," one industry lawyer
described it. These credit risks risks that exist in other forms
as well seemed ready to materialize when the Financial Times'
Tett reported at the end of June that an unnamed investment bank was
trying to unload "several billion dollars" in loans it had made to
hedge funds. If true, "this marks a startling watershed for the
financial system." Bankers had become "ultracreative
in their
efforts to slice, dice and redistribute risk, at this time of easy
liquidity." Low-interest rates, Avinash Persaud, one of the gurus
of finance concluded, had 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 was
no way that hedge funds, which had become precociously intricate in
seeking safety, could avoid a reckoning and "forced to sell their
most liquid investments." "I will not bet on that happy outcome,"
the Financial Times' chief expert concluded in surveying some
belated attempts to redeem the hedge funds from their own follies.
A great deal of money went from investors in rich nations into
emerging market stocks, which have been especially hard-hit in the
past weeks, and if they (leave then the financial shock will be
great -- the dangers of a meltdown exist there too.
Problems are structural, such as the greatly increasing corporate
debt loads to 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 - and keep companies from
going bankrupt when they should. So long as interest rates have been
low, leveraged loans have been the solution. With hedge funds and
other financial instruments, there is now a market for incompetent,
debt-ridden firms. The rules some once erroneously associated with
capitalism -- probity and the like -- no longer hold.
Problems are also inherent in speed and complexity, and these are
very diverse and almost surrealist. Credit derivatives are
precarious enough, but at the end of May the International Swaps and
Derivatives Association revealed that one in every five deals, many
of them involving billions of dollars, involved major errors as
the volume of trade increased, so did errors. They doubled in the
period after 2004. Many deals were recorded on scraps of paper and
not properly recorded. "Unconscionable" was Alan Greenspan's
description. He was "frankly shocked." Other trading, however, is
determined by mathematical algorithm ("volume-weighted average
price," it is called) for which PhDs trained in quantitative
methods are hired. Efforts to remedy this mess only began in June of
this year, and they are very far from resolving a major and
accumulated problem that involves stupendous sums.
Stephen Roach, Morgan Stanley's chief economist, on April 24 of
this year wrote that a major financial crisis was in the offing and
that the global institutions to forestall it ranging from the IMF
and World Bank to other mechanisms of the international financial
architecture were utterly inadequate. Hong Kong's chief secretary
in early June deplored the hedge funds' risks and dangers. The IMF'
s iconoclastic chief economist, Raghuram Rajan, at the same time
warned that the hedge funds' compensation structure encouraged
those in charge of them to increasingly take risks, thereby
endangering the whole financial system. By late June, Roach was even
more pessimistic: "a certain sense of anarchy" dominated the
academic and political communities, and they were "unable to
explain the way the new world is working." In its place, mystery
prevailed. Reality was out of control.
The entire global financial structure is becoming uncontrollable in
crucial ways its nominal leaders never expected, and instability is
increasingly its hallmark. Financial liberalization has produced a
monster, and resolving the many problems that have emerged is
scarcely possible for those who deplore controls on those who seek
to make money whatever means it takes to do so. The Bank for
International Settlements' annual report, released June 26,
discusses all these problems and the triumph of predatory economic
behavior and trends "difficult to rationalize." The sharks have
outfoxed the 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." The BIS (does not
want its fears to cause a panic, and circumstances compel it to
remain on the side of those who are not alarmist. But it now
concedes that a big "bang" in the markets is a possibility, and it
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. For a decade, it admits, global
economic trends and "financial imbalances" have created increasing
dangers, and "understanding how we got to where we are is crucial
in choosing policies to reduce current risks." The BIS is very
worried.
Given such profound and widespread pessimism, the vultures from the
investment houses and banks have begun to position themselves to
profit from the imminent business distress a crisis they see as a
matter of timing rather than principle. Investment banks since the
beginning of 2006 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 danger of defaults among highly leveraged firms.
There is now a growing consensus among financial analysts that
defaults will increase substantially in the very near future. But
because there is money to be made, experts in distressed debt and
restructuring companies in or near bankruptcy are in greater demand.
Goldman Sachs has just hired one of Rothschild's stars in
restructuring. All the factors which make for crashes excessive
leveraging, rising interest rates, etc. exist, and those in the
know anticipate that companies in difficulty will be in a much more
advanced stage of trouble when investment banks enter the picture.
But this time they expect to squeeze hedge funds out of the
potential profits because they have more capital to play with.
Contradictions now wrack the world's financial system, and a
growing consensus now exists between those who endorse it and those,
like myself, who believe the status quo is both crisis-prone as well
as immoral. If we are to believe the institutions and personalities
who have been in the forefront of the defense of capitalism, and we
should, it may very well be on the verge of serious crises.
Gabriel Kolko is the leading historian of modern warfare. He is the
author of the classic Century of War: Politics, Conflicts and
Society Since 1914 and Another Century of War?. He has also written
the best history of the Vietnam War, Anatomy of a War: Vietnam, the
US and the Modern Historical Experience. His latest book, The Age
of War, was published in March 2006.
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