Mar 23, 2008

March 17, 2008: Rhyme of the Ancient Marriner, Lipstick on the Pig, House of Cards

Marriner S. Eccles was a banker from Utah who, after making himself a millionaire in his early 20’s, was later appointed to the Federal Reserve Board and then promoted to Chairman of the Federal Reserve by Franklin Roosevelt in 1934 where he continued to serve until 1948. In 1951 he wrote his memoirs, entitled Beckoning Frontiers, in which he explained what he believed to have been the cause of the Great Depression.

As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth—not of existing wealth, but of wealth as it is currently produced—to provide men with buying power equal to the amount of goods and services offered by the nation’s economic machinery. (Emphasis in original.). Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind
of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips are concentrated into fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.

“That is what happened to us in the twenties. We sustained high levels of employment in that period with the aid of an exceptional expansion of debt outside of the banking system. This debt was provided by the large growth of business savings as well as savings by individuals, particularly in the upper-income groups where taxes were relatively low. (Emphasis added.)
Private debt outside the banking system increased about fifty per cent. This debt, which was at high interest rates, largely took the form of mortage debt on housing, office and hotel structures, consumer installment debt, broker’s loans, and foreign debt. (Emphasis added.) The stimulation of spending by debt-creation of this sort was short-lived and could not be counted on to sustain high levels of employment for long periods of time. Had there been a better distribution of the current income from the national product—in other words, had there been less savings by business and the higher income groups and more income in the lower groups—we should have had far greater stability in our economy. (Emphasis added.) Had the six billion dollars, for instance, that were loaned by corporations and wealthy individuals for stock-market speculation been distributed to the public as lower prices or higher wages and with less profits to the corporations and the well-to-do, it would have prevented or greatly moderated the economic collapse that began at the end of 1929. (Emphasis added.)

“The time came when there were no more poker chips to be loaned on credit. Debtors thereupon were forced to curtail their consumption in an effort to create a margin that could be applied to the reduction of outstanding debts. This naturally reduced the demand for goods of all kinds and brought on what seemed to be overproduction, but was in reality underconsumption
when judged in terms of the real world instead of the money world. This, in turn, brought about a fall in prices and employment.” (Emphasis added) (1)

The result was a downward spiral in which constricted demand produced greater unemployment which in turn further reduced demand, creating greater unemployment until, at last, a bottom of sorts was reached. When the dust had finally cleared, from the collapse of this financial house of cards, the vicious circle of deflation had left nearly 1/3 of the entire working population unemployed and the nation’s income reduced by 50%. What followed was a decade-long period of economic agony relieved only by the coming of world war.

This is the most succinct explanation that I have read of what went so terribly wrong. Coming from one who was not only, so to speak, ‘present at creation’, but who was charged with managing the nation’s money supply during the aftermath, it is impossible to discount the views of the good Chairman. Many revisionists, Milton Friedman among them, have been about the business of smearing the historical record but as John Kenneth Galbraith remarked in a television interview late in his life “they’re simply wrong”. “They weren’t there”, Galbraith said, “they don’t know.” Given the choice between Milton Friedman and John Kenneth Galbraith, I’ll take Harvard’s Galbraith any day.

What is striking here is that the Chairman identifies the concentrations of wealth, predatory lending, high interest rates, and massive consumer debt as all contributing to constriction of aggregate demand which triggered a deflationary spiral that brought about the total collapse of the world financial structure.

Last week saw the collapse of Bear Sterns, one of the most venerable names on Wall Street and the nation’s fifth largest investment bank. (2) The company had demonstrated wisdom and restraint in the 90’s by avoiding a too-great involvement in the craze, but instead specialized in hedge funds and real estate posting earnings that had its stock selling at a high of $171.00 a share.(3) But leveraged at over 30 to 1, “meaning that it borrows more than 30 times the value of its $11 billion equity base,” (3) the coffers at the company “significantly deteriorated”’ within a 24 hour period as rumors about the bank’s situation fueled the Wall Street version of a run on the bank. Central bankers tapped a rarely used Depression-era provision to provide loans, and said they were ready to provide extra resources to combat an erosion of confidence in America’s biggest financial institutions” (2) as fears of greater panic spread.

It was reported that “nearly half the value of Bear Stearns, or about $5.7 billion, was wiped out in a matter of minutes as investors felt the bailout signaled that the credit crisis had reached a more serious stage, and now threatens to undermine the broader financial system—the U.S. economy.” (2)

Calls were made in the night to JP Morgan Chase and to the Federal Reserve which used depression era authority to lend and secure the monies necessary for JP Morgan to stabilize the situation. Over the weekend it was announced that JP Morgan Chase had purchased Bear Stearns outstanding shares which were selling at week’s end at $30.00 a share for $2.00.

In the meantime Fed Chairman Ben B Bernanke who had issued fresh warnings Friday about “a gathering wave of home foreclosures bearing down on American communities” (4), met with President Bush and the Secretary of the Treasury over the weekend to determine the steps necessary to reassure the jittery markets and prevent wholesale panic from stampeding Wall Street. To that end the Secretary was on all the talk shows Sunday morning reassuring both Wall Street and the public that all would be well. The President made a rare weekend appearance and, putting lipstick on the pig, reassured the nation that while it is in for a ‘rough patch’ that the economy is, nevertheless, ‘fundamentally sound’. It is, of course, not. One must keep constantly in mind that whatever this President says about anything belies the fact that reality is precisely the opposite.

What are inescapable are the parallels between the situation now and in the late 20’s. Wealth has been concentrated in the upper classes and is being generated by financiers not manufacturing. The public is up to its eyebrows in debt, wages are stagnant or declining, inflation is savaging the standard of living. The ability of the economy to sustain mass production—in this case housing and automobiles—has become problematic. But the Boomers, ever an innovative lot, have conjured up even more frightening demons creating exotic new ways to concentrate wealth and removing the firewall that had kept our financial institutions separate from the financial casino’s that the markets represent.

A few years before her death columnist Molly Ivins expressed concern about the growing use of what are called derivatives and hedge funds in the financial world. Derivatives are “financial instruments whose value is derived from the value of something else. The main types of derivatives are futures, forwards, options and swaps” (5) in which trading, or speculating, can occur on anything from economic reports, indexed energy prices, commodities, freight, inflation, insurance, weather, credit, or property” . At some level these instruments are clearly beneficial as when a farmer sells his wheat or corn at the beginning of the planting season so that he has capital to run his farm. A price is reached; a bargain struck in which the farmer gets his money and the buyer gets claim to the product betting that the price will go up in the interregnum. Sometimes one wins, sometimes one loses, but on balance because of an undercurrent of inflation, both make money. The idea behind these instruments was to spread risk and build predictability and stability in the marketplace. And, for the most part, they work. But, like everything else concerning The Generation of Swine, left to their own resources things tend to get a bit pathological. There are some real problems with these instruments if they are not used wisely:

1. The use of derivatives can produce large losses. “Derivatives allow
investors to earn large returns from small movements in the underlying
asset’s price. However investors could lose large amounts if the price
of the underlying moves against them significantly.”(5) This is the threat posed by the current real estate bubble.

2. Derivatives “expose investors to counter-party risk. (5) (Emphasis original) by spreading the risk an ensuing financial crisis can negatively impact a greater portion of the economy.

3. Derivatives “typically have a large notion value” (5) (Emphasis original) meaning that their use “could result in losses that the investor would be unable to compensate for. The possibility that this could lead to a chain reaction in an ensuing economic crisis has been pointed out by legendary investor Warren Buffet.

4 Derivatives “massively leverage the debt in an economy.(5) (Emphasis
original) making it ever more difficult for the underlying real economy to service its debt obligations and curtailing real economic activity, which can cause a recession or even depression.” (5). This was, as you recall the reason cited by Chairman Eccles as the cause of the Great Depression.

While these instruments can be used to stabilize prices and markets and even cushion the impact of an economic downturn, carried to excess they become as any economic activity—a threat to the stability and the function of the marketplace and the economy.

We have already witnessed some of the deleterious effects of these investments in the marketplace. In 1994 a young recent graduate of one of the top business schools was left unsupervised. What transpired, over the course of several months, was the over commitment of the assets of Barings Bank to the investment in derivatives which led to the bankruptcy of the bank that had financed the Louisiana Purchase. This was followed by the bankruptcy of Orange County California in 1994, Long-Term Capital Management in 2000, the loss of 6.4 billion dollars “in the failed Amaranth Advisors fund,” when the price of natural gas plummeted in 1996, and the loss of 7.2 billion by Societe Generale in January 2008. (5) To put the widespread use of derivatives and hedge funds into perspective, legendary investor Warren Buffet has called derivatives “financial weapons of mass destruction”. (5)

How prevalent are they? Derivatives are traded in two fundamental ways. There are Over-the-counter (OTC) derivatives, “contracts that are traded (and privately negotiated) directly between two parties without going through an exchange or other intermediary. Products such as swaps, forward rate agreements and exotic options are almost always traded in this way. The OTC derivatives market is huge. According to the Bank for International Settlements, the total outstanding notional amount in USD (United States Dollars) is 516 trillion (as of June 2007) (Emphasis added). This dwarfs in size the 170 trillion dollar estimate of the wealth of the entire planet (5). The 516 trillion in OTC derivatives is based on a gross market value of 11 trillion dollars (see footnote 1. source 5), in what we appears to be roughly the amount equal to the Gross Domestic Product of the U.S. economy leveraged at about a 50 to 1 ratio in speculative transactions.

In addition, the market for Exchange-traded derivatives (ETD) which are traded among other places at the Korean Exchange, the Eurex, and the CME group—which includes both the Chicago Merchantile Exchange and the Chicago Board of Trade—“the combined turnover in the world’s derivatives exchanges totaled 344 trillion during Q4 (Quarter four ) 2005. (Emphasis added). (5)

Beginning about 1973, as Capital went about the business of what Capital always does—reconfiguring itself into ever more exotic forms for the purpose of maximizing profit and avoiding regulation and taxation, there has been a steady movement of capital into derivatives and hedge funds. These funds have clearly transcended their original purpose and are now used to speculate on the movements of currencies, inflation, interest rates, and market indexes. This is all bad enough but what poses the immediate threat to the health of the world economy is the enormity of the sums now invested in what are, in effect, huge casinos. Derivatives alone dwarf national economies, now totaling over 5 times the entire Gross Domestic Product of the United States of America. This is the house of cards that the Generation of Swine have, in their greed, erected. And now the table is beginning to shake.


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