Bernanke Discovers a Weak Link in the System

The Financial Times reported that the chairman of the Federal Reserve Board is now concerned about the “use of tri-party repo and the systemic risks in this crucial, but little understood area of finance.”

“Recent experience demonstrates the need for additional measures to enhance the resilience of these markets, particularly as large borrowers have experienced acute stress,” said Mr Bernanke this week.

The tri-party repo market is indeed crucial but “little understood”? Perhaps only by the Fed. Witness the chairman’s comment about “experience demonstrates.”

This is no place for a discussion of categorical imperative, but I must insist that if you know anything about the tri-party repo market, you would not need experience to tell you what is likely to follow, in the same way that if someone is throwing knives at his friend, you would not need experience to know that eventually the friend is going to get hurt.

I wrote in detail about the tri-party repo market and its systemic implications almost a year ago. I wrote:

In the context of the discussion of a crisis centered around liquidity and credit risk, the most critical thing we must know about the structure of markets is the function of the tri-party repo market.

Your can read the full entries here and here.

If you happen to know Bernanke’s email send him a link as well. With Larry Summers eyeing his job, the chairman needs all the help he can get.

A Coded Admission

Over coffee this Sunday afternoon (somehow this line reminded me of Aznavour’s “café-crème” line in La boheme) I read the reminisces of 5 former Bear Stearns executives in the New York Times. The paper had decided to visit them a year after the firm’s demise.

It was a wasted 10 minutes. Like a prime-time Hallmark sponsored TV special, it only confirmed my prejudices. Not one of the 5 – and except for one saleswoman they were all senior people – had any clue as to what had taken place. All focused on themselves and their hardship. Not one of them had a word about the larger issues that the Bear Stearns collapse signified. That included the firm’s ex vice-chairman who begged the readers to remember Bear Stearns for its – of all things – charitable givings.

I only hope that when future generations think about Bear Stearns, if they do at all, they will remember its philanthropy.

This “if they do at all” is incriminating. It speaks of a self-doubt that no one reaching vice-chairmanship of a place like Bear Stearns could possibly afford to possess; the swagger of these guys was something to behold. The expression, rather, is from T. S. Eliot:

Those who have crossed
With direct eyes, to death’s other Kingdom
Remember us – if at all – not as lost
Violent souls, but only
As the hollow men
The stuffed men.

Maybe I am over-interpreting, but I think in reaching to T.S. Eliot whom he must have remembered from college years, the ex vice-chairman of Bear was admitting to himself and to those who could decode him that he had been a hollow man all along.

A Haunting Picture

The Financial Times reported that cargo ships are being used as the storage place for new cars because: i) cars are piling up due to lack of demand; and ii) ships are idle due to lack of cargo. Two machines, expressly made for transporting commodities, are forced into a state of idleness – compound idleness, really, one inside the other.

This is beyond allegorical.

Motion is the form of the existence of the matter. It is also the form of the existence of capital; capital could only be understood as a thing in motion. A cargo ship is capital but only by virtue, and in consequence, of its capacity to move. A new car is also capital to the company that produced it. But for the profit to be realized, it must be sold. Unsold cars in idle cargo ships is capital laid to waste through and through. In a Capitalist system that functions on the basis of employment of capital, that is the picture of death on a grand scale, which is why a picture of idles ship is haunting. It is the out-of-ordinariness of a “walking, loitering, hurried” market in the age of destruction.

Palan-doozan who know nothing about these matters pressure the banks to lend. Banks do not need pressure to lend. They are in business for that very purpose. But there is no place for the capital to go, thanks to the destruction of its employment opportunities by speculative capital. Speculative capital moves in and withdraws rapidly, which means that it also destroys rapidly. Hence the suddenness of the current collapse and the unprecedented pace of the job losses.

The Education of a Reporter

To study the properties of sub-atomic particles, physicists use particle accelerators to smash the atoms at high speed. The ensuring destruction creates extreme conditions in which the particles reveal new properties.

The economic/financial destruction brought about by the speculative capital has likewise opened up opportunities to learn economics and finance, if only one is willing to look.

A while back, I wrote that the Financial Times’ Gillian Tett is among the keener observors of the global financial collapse. Recently, writing about the upcoming G20 summit in London where the main agenda is expected to center around containing the crisis, she commented on the difficulties of regulating the markets:

The past decade of frenetic financial innovation and globalisation has created a western banking system where numerous entities are entwined in some unpredictable and near-indefinable ways. Just think of the chain reactions unleashed by Lehman Brothers’ collapse.

Thus, the $64 trillion question now is whether the risks created by this “interconnectivity” can be effectively controlled – without simply banning all entrepreneurial activity or innovation from finance? It is a fiendishly difficult circle to square.

The driver of the “frantic financial innovation and globalization” is of course speculative capital. The “interconnectivity” Tett is referring to is the linkage of markets brought about by the arbitrage activities of speculative capital. Tett knows none of these but she has noticed the tension between regulation and the way markets operate. The financial system cannot be regulated without banning “entrepreneurial” activity and “innovation”, which she vaguely suspects and implies, is something bad.

Let us help this perceptive reporter with the problem, beginning with a clear statement of the case.

1. Capital must expand, not because expansion is “good” but because “expansion of capital is the condition for its preservation.”

2. Expansion of speculative capital takes place through arbitrage. Arbitrage opportunities rise randomly and must be exploited rapidly. Speculative capital is thus nomadic and mobile.

3. Speculative capital is self destructive; it eliminates opportunities that give rise to it.

4. To rein in the self-destructive tendency of speculative capital, its movement must be reined in. That means blocking the expansion of speculative capital and destroying the mechanism of its self-preservation.

So what is to be done? Let speculative capital destroy the markets or suffocate it through regulation? That is Gillian Tett’s $64 trillion question. She calls the problem fiendishly difficult because she realizes there are not good options.

We could eliminate speculative capital. Speculative capital dominates the financial markets in the sense that it imparts the mode and the consequences of its operations to markets, making them appear as markets’ own characteristics. Hence, the increase in volatility, decline in spreads, and the bias towards short-trading horizons that have become the feature of markets across the globe.

Quantitatively, however, speculative capital is a relatively small portion of the mass of finance capital in circulation. It is within the realm of possible to curtail and even eliminate it altogether. That could be done through prohibiting hedge funds, proprietary trading desks of banks, day trading, derivatives, cross-border and cross-market arbitrage – in short, all vehicle through which speculative capital operates.

But as I showed in Vol. 1, the rise of speculative capital is logical and not accidental. The rise in volatility and linkage of markets and products, for example, increase liquidity. The fall in spreads makes financial transactions cheaper. In consequence, the markets become “efficient”, i.e. relatively less costly, to traders and investors. Within the prism of cost-benefit analysis, this efficiency is an incontestable fact. It was constant emphasis on this point – and the chicanery of framing all the issues in the cost-benefit framework – that made hollow men such as Milton Friedman seem to “have a point”.

Returning to our subject, the choices are now more sharply defined. To prevent speculative capital from destroying markets, we can choose to eliminate it. But that would entail returning to the crude days of bygone eras and more costly financial markets. With the profit margins under constant pressure, that is hardly an option.

We have just run into a conceptual wall. The problem, as presented, is insoluble. Both alternatives lead to the same dead end.

The solution lies in the realization that the seeming no-way-out is the result of the development of a contradiction that existed within speculative capital and finance capital since their inception. It is part of their DNA, existing in the latent form and pushed into the surface as a result of the severe financial crisis.

“The limit of capital is capital itself,” Marx wrote. Until recently, few could comprehend this supremely theoretical statement. The statement is cryptic because it contains information that cannot be squeezed into a sentence. It could only be understood if it is arrived at; it cannot be given.

Gillian Tett not only comprehends it but discovers it. For that, we have the current crisis to thank. Not that she ever was a dilettante, but she could not have noticed the contradiction a year ago. That is how educators get educated.

Next, when she realizes that the crisis is not an aberration but a logical consequence of what came before, she will be well on her way to making a bonfire of finance and economic textbooks, the way a fellow blogger of hers recently suggested. That would place her on the course to solve the next and final piece of the mystery, which is the source of the original contradiction.