Financial Madness at the Fed

The more things change, the more they remain insane.

“Alan Greenspan has welcomed the ability of new technologies in financial markets to reduce transaction costs, to allow the creation of new instruments that enable risk and return to be divided and priced to better meet the needs of borrowers and lenders, to permit previously illiquid obligations to be securitized and traded, and to make obsolete previous divisions among types of financial intermediaries and across the geographical regions in which they operate.”

The words are those of Donald Kohn, a man who is a Fed governor, a Greenspan aficionado, an attendee at the Jackson Hole confab in August, and probably (only history will tell) a jackass. He and other speakers elaborated a view, which is both new and old, and completely mad: that technology, innovation, globalization and sophistication have made the financial world a safer place.

We noted the evidence of these modernizations in this space over the last few years and gave them some precision only a few days ago. Since Alan Greenspan took over at the Fed, levels of debt throughout the entire financial system have increased greatly. Over the past decade, adds Dr. Kurt Richebächer, “consumer debts are up 121%, to $10.7 trillion,” while real consumer income was either stagnant or falling. More alarming, but also more puzzling, is the increase in derivatives. The ISDA reports that international interest rate and currency derivatives outstanding shot from $865 billion in 1987 to $201.413 trillion in 2005. It is these last figures to which Mr. Kohn refers. These sophisticated financial instruments make it possible for 8,000 hedge fund managers, and thousands more money managers spread all over the world, to go long, short, and upside down all day long.

In theory, with so many more ways to protect themselves, and so many people involved in the financial markets, the system is more stable. When one position tanks, the loss is absorbed by thousands of investors and financial intermediaries all over the globe. But in practice, the money managers all tend to do the same thing. They know that they will lose their jobs if they under-perform their peers; if they go along with everyone else, on the other hand, they may all blow up…but it wasn’t their money anyway.

Financial institutions make their money by originating and selling what are inherently risky positions. In a bank-dominated financial system, the banks themselves, and ultimately a banker, stood to gain or lose as the loans came due. If the banker made bad bets, he could be disgraced, broke, and out of business.

But in this new, more sophisticated world, financial institutions create derivative products and sell them to hedge funds. Once sold, the salesmen earn a commission and the risks are transferred to the buyers. The funds have every incentive to take risks. If they win, the managers take a bit part of the gains. If they lose, they suffer no personal penalty. Ultimately, no one knows how risky the system is, or who, exactly, stands to lose if it implodes.

We don’t know any more than anyone else. We only note that the more stable and safe a financial system becomes, the more investors are lured to take risks, and the more financial intermediaries are encouraged to develop new products to help investors part company with their money. Eventually, the lack of perceived risk creates a situation in which real risk is greater than ever. When people think there is no risk, for example, they see no need to save money. But when people have no savings (savings rates in America were recently negative) they are most at risk, and often driven to react in panicky, desperate ways. That is, where we find ourselves today.

It reminds us of the geo-political situation prior to the Great War. That too, was a period of fast innovation, stability, technological progress and globalization. Thinkers at the time came to the same conclusions about these things as Donald Kohn, 100 years later. The world had become too sophisticated for war, they said. Interlocking treaties would serve to prevent any nation from firing its cannons first. New technology made war too devastating to contemplate (or, taking the opposite side of the argument…many argued that technology made it possible to fight a war with few casualties!). And modern, globalized markets meant that war no longer made sense. That was the point made by Norman Angell, in a celebrated book of the time. A nation’s wealth was built on factories and trade, he pointed out. War was now out of the question, because it would destroy wealth.

But in 1914, began the most deadly and expensive war in human history.

Bill Bonner [send him mail] is the author, with Addison Wiggin, of Financial Reckoning Day: Surviving the Soft Depression of The 21st Century and Empire of Debt: The Rise Of An Epic Financial Crisis.