Gabriel Kolko: 'Bankers fear world economic meltdown'

Gabriel Kolko, CounterPunch

On June 18 we published Gabriel Kolko's essay on the enormous instability of
the world'd financial system. In the ensuing weeks Professor Kolko has
enlarged his analysis, and here we offer our readers his updated version.

There has been a profound and fundamental change in the world economy over
the past decade. The very triumph of financial liberalization and
deregulation, one of the keystones of the "Washington consensus" that the
U.S. government, International Monetary Fund (IMF), and World Bank have
persistently and successfully attempted over the past decades to implement,
have also produced a deepening crisis that its advocates scarcely expected.

The global financial structure is today far less transparent than ever.
There are many fewer reporting demands imposed on those who operate in it.
Financial adventurers are constantly creating new "products" that defy both
nation-states and international banks. The IMF's managing director, Rodrigo
de Rato, at the end of May 2006 deplored these new risks - risks that the
weakness of the U.S. dollar and its mounting trade deficits have magnified
greatly.

De Rato's fears reflect the fact that the IMF has been undergoing both
structural and intellectual crises. Structurally, its outstanding credit and
loans have declined dramatically since 2003, from over $70 billion to a
little over $20 billion today, doubling its available resources and leaving
it with far less leverage over the economic policies of developing nations -
and even a smaller income than its expensive operations require. It is now
in deficit.

A large part of its problems is 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.A. 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 they have increasingly become creditors to the U.S.A. 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. Even more, the IMF and World Bank were severely
chastened by the 1997-2000 financial meltdowns in East Asia, Russia, and
elsewhere, and many of its key leaders lost faith in the anarchic premises,
descended from classical laissez-faire economic thought, which guided its
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. The IMF claims that much has been done to prevent the
reoccurrence of another crisis similar to that of 1997-98, but the
international economy has changed dramatically since then and, as Stephen
Roach of MorganStanley has warned, the world "has done little to prepare
itself for what could well be the next crisis."

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 advice - 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. In many investment banks, the traders
have taken over from traditional bankers because buying and selling shares,
bonds, derivatives and the like now generate the greater profits, and taking
more and higher risks is now the rule among what was once a fairly
conservative branch of finance. They often bet with house money.
Low-interest rates have given them and other players throughout the world a
mandate to do new things, including a spate of dubious mergers that were
once deemed foolhardy. There also fewer legal clauses to protect investors,
so that lenders are less likely than ever to compel mismanaged firms to
default. Aware that their bets are increasingly risky, hedge funds are
making it much more difficult to withdraw money they play with. Traders have
"re-intermediated" themselves between the traditional borrowers - both
national and individual - and markets, deregulating the world financial
structure and making it far more unpredictable and susceptible of crises.
They seek to generate high investment returns - which is the key to their
compensation - and they take mounting risks to do so.

In March of this year the IMF released Garry J. Schinasi's book,
Safeguarding Financial Stability, giving it unusual prominence then and
thereafter. Schinasi's book is essentially 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, has become a nightmare.
It has created "tremendous private and social benefits" but it also holds
"the potential (although not necessarily a high likelihood) for fragility,
instability, systemic risk, and adverse economic consequences." Schinasi's
superbly documented book confirms his 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.
Leaving the future to luck is not what economics originally promised. The
IMF is desperate, and it is 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. -- 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, the growth
rate of developing nations in 2004 and 2005 was over double that of high
income nations -- a pattern projected to continue through 2008 -- and as
early as 2003 developing countries were already the source of 37 per cent 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 much less leverage than ever.

At the same time, the far greater demand of hedge funds and other investors
for risky loans, combined with low-interest rates that allows hedge funds to
use borrowed money to make increasingly precarious bets, has also led to
much higher debt levels as borrowers embark on mergers and other adventures
that would otherwise be impossible.

Growing complexity is the order of the world economy that has emerged in the
past decade, and the endless negotiations of the World Trade Organization
have failed to overcome the subsidies and protectionism that have thwarted a
global free trade agreement and end of threats of trade wars. Combined, the
potential for much greater instability - and greater dangers for the rich -
now exists in the entire world economy.

High-speed Global Economics

The global financial problem that is emerging is tied into an American
fiscal and trade deficit that is rising quickly. Since Bush entered office
in 2001 he has 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 long
before the dollar weakened. This conjunction of factors has created
infinitely greater risks 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 that
have been invented since then, and 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 - but 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 Tett 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. Warren Buffett, second richest man in the world, who knows
the financial game as well as anyone, has called credit derivatives
"financial weapons of mass destruction." Nominally insurance against
defaults, they encourage far greater gambles and credit expansion. Enron
used them extensively, and it was one secret of their success - and eventual
bankruptcy with $100 billion in losses. They are not monitored in any real
sense, and two experts called them "maddeningly opaque." Many of these
innovative financial products, according to one finance director, "exist in
cyberspace" only and often are simply tax dodges for the ultra-rich. It is
for reasons such as these, and yet others such as split capital trusts,
collateralized debt obligations, and market credit default swaps that are
even more opaque, 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 this. 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 10 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 this last 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.
More than half of them give preferential treatment to certain big investors,
and the U.S. Security and Exchange Commission has since mid-June 2006 openly
deplored the practice because the panic, if not chaos, potential in such
favoritism is now too obvious to ignore. The practice is "a ticking time
bomb," one industry lawyer described it. These credit risks - risks that
exist in other forms as well - seemed ready to materialize when the
Financial Times' Tett reported at the end of June that an unnamed investment
bank was trying to unload "several billion dollars" in loans it had made to
hedge funds. If true, "this marks a startling watershed for the financial
system." Bankers had become "ultracreative... in their efforts to slice,
dice and redistribute risk, at this time of easy liquidity." Low-interest
rates, Avinash Persaud, one of the gurus of finance concluded, had led
investors to use borrowed money to play the markets, and "a painful
deleveraging is as inevitable as night follows day.... The only question is
its timing." There was no way that hedge funds, which had become
precociously intricate in seeking safety, could avoid a reckoning and
"forced to sell their most liquid investments." "I will not bet on that
happy outcome," the Financial Times' chief expert concluded in surveying
some belated attempts to redeem the hedge funds from their own follies.

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 then the financial shock will be great -- the dangers of a
meltdown exist there too.

Problems are structural, such as the greatly increasing 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 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.

Problems are also inherent in speed and complexity, and these are very
diverse and almost surrealist. 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 recorded on
scraps of paper and not properly recorded. "Unconscionable" was 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. 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 global
institutions to forestall it- ranging from the IMF and World Bank to other
mechanisms of the international financial architecture - were 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. By late June, Roach was even more
pessimistic: "a certain sense of anarchy" dominated the academic and
political communities, and they were "unable to explain the way the new
world is working." In its place, mystery prevailed. Reality was out of
control.

The entire global financial structure is becoming uncontrollable in crucial
ways its nominal leaders never expected, and 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.
The Bank for International Settlements' annual report, released June 26,
discusses all these problems and the triumph of predatory economic behavior
and trends "difficult to rationalize." The sharks have outfoxed the more
conservative bankers. "Given the complexity of the situation and the limits
of our knowledge, it is extremely difficult to predict how all this might
unfold." The BIS (does not want its fears to cause a panic, and
circumstances compel it to remain on the side of those who are not alarmist.
But it now concedes that a big "bang" in the markets is a possibility, and
it sees "several market-specific reasons for a concern about a degree of
disorder." We are "currently not in a situation" where a meltdown is likely
to occur but "expecting the best but planning for the worst" is still
prudent. For a decade, it admits, global economic trends and "financial
imbalances" have created increasing dangers, and "understanding how we got
to where we are is crucial in choosing policies to reduce current risks."
The BIS is very worried.

Given such profound and widespread pessimism, the vultures from the
investment houses and banks have begun to position themselves to profit from
the imminent business distress - a crisis they see as a matter of timing
rather than principle. Investment banks since the beginning of 2006 have
vastly expanded their loans to leveraged buy-outs, pushing commercial banks
out of a market they once dominated. To win a greater share of the market,
they are making riskier deals and increasing the danger of defaults among
highly leveraged firms. There is now a growing consensus among financial
analysts that defaults will increase substantially in the very near future.
But because there is money to be made, experts in distressed debt and
restructuring companies in or near bankruptcy are in greater demand. Goldman
Sachs has just hired one of Rothschild's stars in restructuring. All the
factors which make for crashes - excessive leveraging, rising interest
rates, etc. - exist, and those in the know anticipate that companies in
difficulty will be in a much more advanced stage of trouble when investment
banks enter the picture. But this time they expect to squeeze hedge funds
out of the potential profits because they have more capital to play with.

Contradictions now wrack the world's financial system, and a growing
consensus now exists between those who endorse it and those, like myself,
who believe the status quo is both crisis-prone as well as immoral. If we
are to believe the institutions and personalities who have been in the
forefront of the defense of capitalism, and we should, 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 Century of War: Politics, Conflicts and Society Since 1914
and Another Century of War?. He has also written the best history of the
Vietnam War, Anatomy of a War: Vietnam, the US and the Modern Historical
Experience. His latest book, The Age of War, was published in March 2006.

He can be reached at: kolko@counterpunch.org

Source: CounterPunch
http://counterpunch.org/kolko07262006.html

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"A little patience and we shall see the reign of witches pass over, their
spells dissolve, and the people recovering their true sight, restore their
government to its true principles. It is true that in the meantime we are
suffering deeply in spirit,
and incurring the horrors of a war and long oppressions of enormous public
debt. But if the game runs sometimes against us at home we must have
patience till luck turns, and then we shall have an opportunity of winning
back the principles we have lost, for this is a game where principles are at
stake."
-Thomas Jefferson