[News] Why a Global Economic Deluge Looms

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Thu Jun 15 13:22:08 EDT 2006


http://www.counterpunch.org/

June 15, 2006


"The Demons of Greed are Loose"


Why a Global Economic Deluge Looms

By GABRIEL KOLKO

People who know the most about the world 
financial system are increasingly worried, and 
for very good reasons. Dire warnings are coming 
from the most "respectable" sources. Reality has 
gotten out of hand. The demons of greed are loose.

What is that reality? It includes a number of 
factors. Alone they would be exceedingly serious; 
combined, they are very likely to be lethal.

First of all, the International Monetary Fund 
(IMF) has been undergoing both a structural and 
intellectual crisis. Structurally, its 
outstanding credit and loans have declined 
dramatically since 2003, from over $70 billion to 
a little over $20 billion today, leaving it with 
far less leverage over the economic policies of 
developing nations--and even less income than its 
expensive operations require. It is now in deficit.1

A large part of the IMF's problems are 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. 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 have increasingly become 
creditors to the U.S.2 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.

Equally important, the IMF and World Bank were 
severely chastened by the 1997-2000 financial 
meltdowns in East Asia, Russia, and elsewhere, 
and many of the two institutions' key leaders 
lost faith in the anarchic premises, descended 
from classical laisser-faire economic thought, 
which guided 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.3

Worse yet, 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 advic. These are 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 and 
they have "reintermediated" themselves between 
the traditional borrowers, both national and 
individual, and markets. They have deregulated 
the world financial structure, making it far more 
unpredictable and susceptible to crises. They 
seek to generate high investment returns, which 
is the key to their compensation, and they take mounting risks to do so.

A "brave new world" has emerged in the global 
financial structure, one that is far less 
transparent because there are fewer reporting 
demands imposed on those who operate in it. 
Financial adventurers are constantly creating new 
"products" that defy both states and 
international banks. The IMF's managing director, 
Rodrigo de Rato, at the end of May, 2005, 
deplored these new risks -- risks the weakness of 
the U.S. dollar and its mounting trade deficits have magnified greatly.4

In March of this year the IMF released Garry J. 
Schinasi's book, Safeguarding Financial 
Stability, giving it unusual prominence then and 
thereafter. In essence, Schinasi's book is 
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, 
have become a nightmare, creating "tremendous 
private and social benefits" but also holding 
"the potential (although not necessarily a high 
likelihood) for fragility, instability, systemic 
risk, and adverse economic consequences."

Anyone who reads the data in Schinasi's superbly 
documented book will share his real 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.5 Leaving the future to luck is not 
what economics originally promised. The IMF is desperate, and 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., comprising 
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 and the 
growth rate of developing nations in 2004 and 
2005 was over double that of high income nation, 
a pattern projected to continue through 2008.

As early as 2003 developing countries were 
already the source of 37 percent 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 far less 
leverage than ever. Growing complexity is the 
order of the world economy that has emerged in 
the past decade, and with it has come the 
potential for far greater instability, and dangers for the rich.

High-speed Global Economics

The global financial problem that is emerging is 
entwined with an American fiscal and trade 
deficit that is rising quickly. Since Bush 
entered office in 2001 he had 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 well before the dollar weakened. 
The world now has a conjunction of factors that 
have created a far greater risk 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. 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. She 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 she 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.6 It for reasons such as these, 
as well as others, even more opaque, such as 
split capital trusts, collateralized debt 
obligations, and market credit default swaps, 
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 as much. 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 ten 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 in 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.

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 them the financial shock will be 
great. The dangers of a meltdown exist there too.

Problems are structural, such as the greatly 
increasing ratio of 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 to 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 even on paper.

Problems are also inherent in speed and 
complexity, and these are very diverse and almost 
surreal. 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 
scribbled on scraps of paper and not properly 
recorded. "Unconscionable" was outgoing Fed 
chairman, 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.7 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 
ability of global institutions to forestall it -- 
ranging from the IMF and World Bank to other 
mechanisms of the international financial 
architecture ­ are 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.

* * *

The entire global financial structure is becoming 
uncontrollable in crucial ways its nominal 
leaders never expected. 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. Contradictions now wrack the 
world's financial system, and if we are to 
believe the institutions and personalities who 
have been in the forefront of the defense of 
capitalism, 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 
<http://www.amazon.com/exec/ASIN/1565841921/counterpunchmaga>Century 
of War: Politics, Conflicts and Society Since 
1914 and 
<http://www.amazon.com/exec/obidos/ASIN/156584758X/counterpunchmaga>Another 
Century of War?. He has also written the best 
history of the Vietnam War, 
<http://www.amazon.com/exec/obidos/ASIN/1565842189/counterpunchmaga>Anatomy 
of a War: Vietnam, the US and the Modern 
Historical Experience. His latest book, 
<http://www.amazon.com/exec/obidos/ASIN/1588264394/counterpunchmaga>The 
Age of War, was published in March 2006.

He can be reached at: <mailto:kolko at counterpunch.org>kolko at counterpunch.org.

Note

1 IMF Survey, March 13, 2006, p. 66.

2 Philip R. Lane and G. M. Milesi-Ferretti, 
"Examining Global Imbalances," Finance & Development, March 2006, pp. 38-41.

3 Roberto Zagha et al, "Rethinking Growth," 
Finance & Development, March 2006, p. 11.

4 Raghuram Rajan, in Finance & Development, 
September 2005, pp. 54, 58; IMF Survey, May 29, 2006, p. 147.

5 Garry J. Schinasi, Safeguarding Financial 
Stability: Theory and Practice, pp. 8, 14, 17.

6 Gillian Tett, "The dream machine," Financial 
Times magazine, March 25/26, 2006, pp. 20-26. 
Also Financial Times, March 20, 2006.
7 Financial Times, May 31, 2006; June 8, 2006.


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