GLOBAL FINANCIAL CRISIS: by Jeffry Babb News Weekly
Regulators crack down on speculation
, June 12, 2010
The global economy is now so intertwined that what happens overseas will inevitably affect Australia, as recent events in southern Europe demonstrate.
Fitch, a ratings agency, cut the credit rating on Spain, meaning that Spain will have to pay more to borrow money on the international financial markets. Spain's troubles reverberated around the world and solid German banks trembled. Coupled with the near collapse of the Greek economy, it does not look good for heavily indebted countries, Australia included.
If nothing else, the troubles of the so-called PIGS - Portugal, Italy, Greece and Spain - have laid to rest the division between public and private debt.
Although Australia has low levels of sovereign debt (that is, debt owed by the government), it has massive debts owed by the private sector, mainly banks, which fund their lending through offshore borrowings. If the worst comes to worst, and international financial markets freeze up, the Australian government will have no alternative to taking over the funding of private debt itself, or risk the Australian economy seizing up.
It's not only the PIGS that are in trouble. Some add a second "I", for Ireland. But Ireland has taken drastic measures to cut public spending, and still has its status as the Celtic Tiger, a centre for the European information technology, to fall back on.
The Irish recession, however, is so severe that Australia's Gerry Harvey, the main man behind the Harvey Norman electrical retail chain, has called it a "second potato famine". Harvey Norman's electrical retail chain in Ireland has suffered multi-million dollar losses.
Many commentators have put down the meltdown in European finances to speculation. Speculators buy and sell shares, debt and other financial instruments in the hope of making a quick profit. Economists customarily defend speculators as a means of smoothing markets from rapid ups and downs.
"Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done," said John Maynard Keynes, the famous 20th-century British economist who understood markets so well he made a fortune on the stock market, something well beyond most economic theoreticians.
Much of the current malaise can be put down to trading in derivatives.
"In the broadest sense, derivatives are any financial contracts that derive their value from other underlying assets. However, this brief definition does not really give a true idea of what a derivative is or what it could be. In reality, these instruments run the gamut from the simplest put option purchased to hedge one's personal stock position, to the most sophisticated, dynamic, financially engineered, swapped, strangled and straddled package of bits and pieces. The derivatives market is large (about US$516 trillion in 2008) and experienced very rapid growth through the late '90s and early 2000," writes Helen Simon in Investopedia
In 1988, US Federal Reserve Bank chairman Alan Greenspan stated, "What many critics of equity derivatives fail to realise is that the markets for these instruments have become so large, not because of slick sales campaigns, but because they are providing economic value to their users." But not everyone had a good feeling about this financial instrument. In a 2002 letter to his shareholders, Berkshire Hathaway company chairman and CEO Warren Buffett expressed his concern with derivatives, referring to them as "weapons of mass destruction," a term popularised by George W. Bush to describe nuclear arms.
It certainly looks as if Buffett was right. Buffett, one of the world's richest men and one of the most successful investors of all time, certainly has been justified.
Legislation before the United States Congress may ban or limit what is known as "proprietary trading", that is, speculation by banks on their own account, rather than on behalf of clients. Proprietary trading creates profound ethical dilemmas, as it is often a case that the banks are taking bets against their customers.
Since Buffett first referred to derivatives as "financial weapons of mass destruction" in reference to derivatives, the potential derivatives bubble has grown from an estimated $100 trillion in 2002 to $516 trillion dollars in 2008. In addition, 2008 was marked by the French bank Société Générale's Jérôme Kerviel's orchestration of the largest bank fraud in world history via derivatives trading, a $5 billion loss.
Previous rogue trader incidences include Nick Leeson at Barings Bank in 1995, a billion dollar loss causing bankruptcy for his employer, and David Bullen and three other traders at National Australia Bank in 2004, a $360 million loss. In addition, the subprime credit meltdown of 2007 is estimated in the hundreds of billions of dollars.
In the battle to restrict proprietary trading in the US, the stakes are high. The big banks make billions from proprietary trading. In the end, we can't avoid banks finding new ways to go broke, but at least we can stop the current disaster happening again.