Thursday, April 30, 2009

An Analysis of International Monetary Relations – Part 2: Where We Are

These days, references to the Great Depression and the Bretton Woods system abound. Analogy with the past crises is supposed to shed light on the present.

In analogy, we seek to establish sameness between two disparate objects. “Bone to dogs is like meat to cats” highlights the universal need of animals for food. The analogy works because that need is a defining and unchanging attribute of animals.

History is dynamic. The snapshots of historical events – a Great Depression here, a monetary crisis there – might have some surface resemblance to some aspects of the current crisis, but they could offer nothing by way of understanding the problem at hand. The secret of understanding history is knowing the nature of its dynamism, the way the changes take place.


”A major lesson of the crisis is that the remarkable overall performance of the global economy between 2003 and 2007 contained within it the seeds of its own destruction”.
Thus spoke the U.S. Treasury secretary Timothy Geithner the other day in the Economic Club of Washington.

Has the crisis turned him into a dialectician? “The global economy containing the seeds of its own destruction” – Hegel himself could not have said any better.

The answer is No. His absurd time frame betrays his tenuous grasp of the roots of the crisis. (The time frame is absurd in terms of understanding the crisis, but it is not random. Geithner unwittingly ties the rise of mortgage products with the destruction of Fannie Mae and Freddie Mac; 2003 is about the time Fannie and Freddie were neutered.)


The crisis we are witnessing is not the result of any exuberance in any particular period, however much the exuberance might have played a role in it. It is not the doing of rogue traders, unscrupulous speculators, careless lenders or irresponsible borrowers -- even though these elements were all present. Neither is it a Black Swan, a 100-year flood, or a once-in-a-lifetime event. All this by way of saying that it is not an aberration. It is the natural, necessary and inevitable consequence of the working of the so-called Anglo-American model of finance, rightly claimed as the most developed form of finance. This point is critical. The crisis came about because of, not despite, the system’s sophistication and is an inseparable part of it. The moment we approach it as an exception, we are lost.


The point about “natural, necessary and inevitable” outcome must be understood. The adjectives refer to a state of affairs brought about by the internal developmental logic of the system. Only knowing, conscious human action can interrupt or derail such process. Good intentions, grand ideals, great expectations and the like would not do; they are literally immaterial.


In the early days of television, there were grandiose predictions that the new medium would bring culture to masses. Banjos in Alabama were going to play Appassionata, mortgage-ridden farmers around Chicago, Chaconne. We know how that one turned out.

There is nothing preordained about TV turning into a vast wasteland. It could bring culture to masses. But the “business model” sets the direction and limitation of what can be achieved. Trash TV is the natural, necessary and inevitable fate of a medium whose raison d’etre is selling stuff to masses.

The same goes for the notion of the Internet bringing literacy to the masses. Or microloans brining prosperity to Indian peasants. Or casinos solving the housing and employment problem in Atlantic City – remember that one? You get the idea.


Finance capital has a distinct mode of existence which creates the realm of finance. The uncritical eye sees this sphere as something independent, different and separate from the “real economy”. Hence, the nonsense about whether the “real economy” – like pornography, never defined but always assumed to be understood – could be affected by the losses in Wall Street. You recall this was the intellectual question of the last year.

In reality, finance capital is an integral part of the economic system of a country. In its less developed stages, when its size is relatively small compared to the industrial capital and its activities limited to simple lending and borrowing, it has limited sway over the economy. As its size, reach and complexity increases, its influence likewise grows. This real-life development is reflected in the rise of the academic discipline of finance, which, originally a backwater part of economics, has come to dominate the mother science.


In its latest, historically most developed form, finance capital morphs into speculative capital. This is a gradual process, with the size of speculative capital constantly increasing. At this stage, trading, the mode of existence of speculative capital, begins to influence financial markets to the point that even public finance decisions must be made with an eye to accommodating its needs.
The government has taken the first step toward a revival of the 30-year bond, an unexpected shift that could provide an important tool to grapple with the nation’s troublesome budget deficit and its creaky pension system.
This is The New York Times, reporting the Treasury’s decision to reissue the 30-year bond. The paper frames the decision as the creation of a budget management tool, but few paragraphs later in the same article, the Treasury officials flatly refute that spin.
Treasury officials said yesterday that the decision had nothing to do with the budget deficits.
So what prompted the decision? Perhaps the following – again, from the same article:
Wall Street ... has been clamoring for a revival of the bond almost since it was abandoned in 2001 ... The 30-year bond is a longer-term security that is more volatile than shorter-term securities. And Wall Street traders love volatility because it is an opportunity to make money. The committee from Wall Street that advises the Treasury on the sales of government debt recommended this week that the 30-year bond be revived.

Still, where exactly was Wall Street's interest in reviving the long bond? Were there not sufficient amounts of Treasuries to play with?

The answer is No. The daily volume of the repo and tri-party repo market alone in which the U.S. Treasuries exchanged hands had reached and surpassed $6 trillion. That is, the entire public debt of the U.S. government was being turned over once a day. What was driving this feverish activity?

I touched upon this question in several places, including here, in discussion the structure of the financial markets in the U.S, and also here and here. I will return to this subject in detail in Vol. 4 of Speculative Capital. The critical point to note is that an increase in demand increases the price of treasuries and pushes their rates down. Treasuries rates are the frame of reference for all commercial rates in the U.S. and much of the globe. In this way, finance capital encourages borrowing by all parties, large or small, public or private. The U.S. consumer, whose real income has been falling since 1971, sees this as an opportunity. So the consumer debt soars and the reach of finance capital is extended.


I repeat: finance capital is an integral part of a nation's economy. As it develops and expands: i) its reach extends beyond the national borders; and ii) it becomes the catalyst and enabler not only of the monetary relations but the economic relations as well. Globe-spanning operations of large corporations presuppose and rely on “sophisticated” capital markets.


As an example of economic relation, take the case of WalMart. The company produces virtually all its products in China. That is the main reason China has amassed $2 trillion reserves, about $800 billion of which is invested in treasuries.

Meanwhile, cheap imports from China enable WalMart to reduce the cost of living for all workers. That helps keep wages low and profits high for all corporations. At the same time, workers have to borrow the shortfall in their budgets due to their low wages. It is a perfect one-two punch.


The first and foremost order of a system is self-preservation. The “order” is not so much a conscious mandate but a built-in mechanism; a system without such mechanism could not exist and would not last.

Finance capital’s immediate self-interest, expansion through maximizing profit, collides with and contradicts its existence as a going concern. This is most vividly seen in the case of speculative capital – capital engaged in arbitrage. Arbitrage is self-destructive; it eliminates opportunities that give rise to it. The destruction you are seeing in all spheres of the economy, not in businesses anymore but in the business models, is the natural, necessary and inevitable consequence of what transpired in the past 35 years.

That is where we stand now, where money, to the tune of $13 trillion that the U.S. government has committed to every sphere of economic activity, cannot solve an economic crisis. That is what is qualitatively different about this crisis. And that is why it is no use looking back at the past crises for solutions; none will be found.

Wednesday, April 22, 2009

A Good Man in a Bad Business

David Kellermann, the acting CFO of Freddie Mac, was found dead of apparent suicide. He was 41.

Alas, poor David Kellermann. I knew him not. The news reports said that he was a “hard worker”, “a good guy”, with “extraordinary work ethic” and “integrity”. His apparent suicide in a weird way confirms that; imagine a good man with extraordinary integrity witnessing the going-ons in the mortgage industry. But being good is not enough. Like the charitable work of society ladies – sending get-well cards to wounded soldiers – it could be perfectly useless. Like the cultural activities of financiers – takeover artists underwriting operas – it could be downright detrimental. Sartre developed the notion of praxis – the activity of an individual or group in an organization with an eye toward some end – precisely to reach beyond the inadequacy of this in-itself do-gooding.

I cannot speculate on what David Kellermann was going through; if I did that I would be writing fiction. But I am certain that he did not know about the history of the destruction of Fannie Mae and Freddie Mac that I chronicled in three parts here, here and here. Had he known, he would have been a more cynical man, but he would be alive now.

Sometimes ignorance is bliss. Sometimes it kills you. Poor David Kellermann.

Tuesday, April 7, 2009

An Analysis of International Monetary Relations – Part 1: How We Got Here

No economic event in the 20th century had a greater impact on world affairs than the Bretton Woods Agreement. The regime of fixed exchange-rates that it established and the collapse of that system after 25 years under the strain of its internal contradictions are both watershed events in the history of the world in general and finance in particular.

The foundation and the driver of the Bretton Woods system was the convertibility of the U.S. dollar to gold. The U.S. undertook to deliver 1 troy ounce of gold for every $35 dollars that foreign nations’ central bank presented to it. The exchange rate of major currencies was fixed against the dollar and, by extension, one another, to prevent manipulative devaluations. At the time of the signing of the Agreement in 1944, approximately 75% of the world’s gold stock was in the U.S., so there was no question about the country’s ability to honor its promise. (The stock was created because the U.S. companies that sold goods to the warring parties sensibly refused the European currencies for payment and demanded gold instead.) Dollar holdings, furthermore, earned interest. Gold did not, and had additional insurance and storage costs. So the foreign central banks that got hold of dollars did not convert them into gold. They kept them in dollar-denominated assets and earned interest. The dollar became as good as gold – even better.

In this way, a national currency became the means of settling the international balance of payments. It was an unprecedented regime. The U.S. could create dollars from thin air – via either bank reserves or the actual printing of paper money – and present them as payment for the goods and services that it acquired from abroad. This was an extraordinary power and privilege that solidified the 20th century as the American Century.

You know the rest. To finance his expensive War on Poverty and an escalating war in Vietnam, President Johnson resorted to creating money. Soon, the volume of dollars in the international channels of circulation reached a point where it was impossible to redeem them at the rate of $35 per ounce of gold; the redemption would have emptied Fort Knox many times over. The time had come for the Bretton Woods Agreement to go.

On August 15, 1971, President Nixon went on TV to announce a series of measure to fight inflation – as dollars were now everywhere, causing a rise in prices – and mentioned, almost in passing, that the U.S. would no longer honor conversion of dollars to gold; if you were holding dollars, you were stuck with them. That was the end of the Bretton Woods system and the regime of fixed exchange rates.

For the next couple of years, an informal arrangement by the major central banks managed to hold the exchange rates within a narrow band. In 1973, that arrangement, too, collapsed. Currencies were thrown into the market place to find their “correct” exchange rate in the interaction of supply and demand.


The “oil crisis” hit the U.S. in 1973. Virtually overnight, the price went from $2 to $8 a barrel.

Everyone knows the crisis was caused by the “oil embargo”, a piece of knowledge qualitatively on par with knowing that Mrs. O’Leary’s cow caused the Great Chicago Fire.

Here is what happened.

Prior to 1973, a barrel of oil was at $2:

What would happen if the left side of the above equality increased? We would then have:

In economic parlance, this condition is called an oil glut. In an oil glut, oil is cheaper because the same $2 would now buy more oil.

Now, what would happen if the right side of the equality increased?

In this situation, confronting the same barrel of oil is many more dollars; more dollars correspond to one barrel of oil, which is another way of saying that more dollars are needed to buy oil.

This condition is not called dollar glut. It is known as the “oil crisis”.


Just how many dollars were in circulation could be surmised from the price of gold that passed $800 in the 80s, which is why, long after the “embargo”, the oil price kept going up. The driver of the price was not the scarcity of oil, but the abundance of dollars.


Conservatives applauded the collapse of Bretton Woods. The gold would now stay in the U.S. (The Wall Street Journal still calls the event “closing the gold window”, implying a beneficent banker to the world who got tired of being beneficent.) Milton Friedman, given open access to the media, endlessly made the case that floating-rate mechanism would solve the balance of payment problems once and for all. If a country’s balance of payments deteriorated, its currency would weaken, resulting in less import and more export. This would restore “the equilibrium”. That is what he actually said.

More astute, less partisan people, though, mourned the collapse of the Bretton Woods. They though it signaled the end of the U.S.’s global supremacy. Indeed, it was difficult to see how the loss of a proverbial golden goose – the ability to print dollars to pay for goods from all over the world – could be anything but a setback. Even an astute practitioner of international finance such as Paul Volker titled his book, Changing Fortunes, by which he meant the fortunes of the U.S.


The realm of finance capital is the realm of theory. Practitioners know as little about it as biased ideologues and outright fools, which is why no one saw what was coming.
In the post-Bretton Woods chaos, it became impossible for corporations to plan with any degree of confidence. An adverse exchange-rate movement could wipe out the hard-earned profits of a full quarter or even a year. There had to be a regulating mechanism. In the absence of government authority, the only remaining source of discipline was private finance–finance capital–which stepped in and assumed the role of regulator.

Governments achieve stabilization through decree; finance capital does it through arbitrage. The most important point in the rise of arbitrage trading is that the practice develops logically from hedging and, on paper, is indistinguishable from it.

I showed in Vol. 1, how, from the ashes of Bretton Woods, speculative capital rose to dominate the financial markets. The new phenomenon seemed to have the potential for boundless expansion, only if the “stifling regulation” inhibiting its growth could be done away with. That brought Reagan to power. And then Thatcher.

Awestruck academics could not see the speculative capital. It was too abstract a concept to lend itself to their comprehension. What they noticed was that a “new paradigm” had taken hold in the U.S. and U.K where credit could be expanded on-demand without limits.

The currency of the new paradigm, the material form in which it manifested itself, was the dollar. It had to be, thanks to its abundance, ease of conversion and universal acceptability. So, once again, the U.S. and its currency assumed centrality in the world of international finance, only this time, the U.S. could issue dollars without any accountability or the need for keeping an anxious eye on its gold reserves. Good times were going to be had by all involved.

The “paradigm” lasted about 25 years, the same time it took for the Bretton Woods to collapse. This one ended in 2007.