To the precipice
An international finance expert looks at the instability of the global financial system, and how people will be affected by the coming collapse of stock markets and economic deflation.
"Greed has taken hold of their hearts and senses, and, as if in a dream, they walk wild-eyed to the precipice." - Benjamin Creme's Master, July/August 1998, Share International.
Since most of the Western world is yet to experience crashing stock markets or deflation, it might be of interest to ask ourselves what might we, as individuals, and collectively as citizens of our respective countries, expect in the months ahead? How will we be affected by the process of deflation, collapsing markets and economies, and the systemic risk posed by the global derivatives trade?
The destructiveness of global deflation has not been seen in the world since the 1930s. Deflation is simply the value of money increasing relative to goods and services and all other asset classes. In a deflation, cash is king. Because prices of almost everything are steadily declining, consumers delay purchases in the knowledge that whatever they want will be less expensive tomorrow. As consumers withhold spending, corporate sales and earnings decline. This results in layoffs, which, in turn, usher in steeper price declines followed by even greater layoffs. This vicious spiral is difficult to stop once begun.
Witness Japan today, which has been fighting deflation for most of this decade, but which has a savings rate of nearly 20 per cent. Contrast this with the US, where 17 years of a booming economy has resulted in a savings rate that is actually negative. In order to perpetuate unsustainable lifestyles, Americans have borrowed their way into an apparent prosperity. There has, indeed, been a tremendous increase in the price of both real and paper assets, but, simultaneously, there has been an equally large expansion of debt at all levels: individual, corporate, and government.
This illusion of wealth is a trap. It leads to the inevitable problem which arises when the paper assets 'bubble' bursts and reverses direction. The debts that were accumulated on the way up are still owed, but the assets which were used as collateral, such as a stock portfolio or a house, are found to be shrinking in value. But lenders want their money, and these debts must either be paid, forgiven, or defaulted upon. It is the paying of debts which really adds fuel to the fire of deflation. Assets are liquidated at any price in order to stop foreclosure or to keep food on the table. Couple this with corporate layoffs, and one can gain a sense of what much of the world is currently experiencing, what is in store for us, and why it can be so difficult to stop.
In the 1930s much of the blame for the crash was placed on over-speculation, especially in light of the fact that buyers could borrow up to 90 per cent of the purchase price of a stock. As one might imagine, this led to much more stock being purchased than would otherwise have been the case. This helped push stock prices up sharply, leading to the famous crash. But how do we compare to the time of the 1929 crash? Today the US Government-mandated borrowing limit on stock purchases is 50 per cent, and this limit has been in place for many years. On the surface, it would appear that we are taking on less risk than did our predecessors. But what the 1920s lacked, we have in abundance, namely, a much greater access to credit. With the proliferation of credit cards and second mortgages, it is quite easy to borrow one's way into a stock market portfolio. This is being done at an appreciable level by the new breed of speculators as they quit their jobs to become short-term day traders, speculating on the minute-by-minute price changes on volatile Internet-related stocks.
And while this may not be the experience of the average American, by definition, since he has a negative savings rate, he must be borrowing to finance at least some of his stock market investments. He may not be taking a cash advance on his credit cards and sending it to his broker, but, in effect, he is accomplishing the same thing. A brief example will make this clear. A family is earning $80,000, and it takes everything they make to support their lifestyle. They did manage to contribute $3,000 to their stock market mutual fund, but over this same time period, their credit card balances ballooned by $4,000. In effect, they have borrowed their mutual fund purchase. This is being done on a surprising scale in the US.
In the US, the stock market has attained the status of a religion. Its mantra is '20 per cent returns in perpetuity'. Daily the cult of equities is pounded into the consciousness of an unsuspecting public via extreme levels of newspaper, magazine, and television advertising. Corporate oversight, ostensibly the responsibility of accountants and government regulators, is quickly discarded as rising stock prices become the social imperative. Wall Street 'experts' dream up new techniques to enable companies to demonstrate sharply rising earnings per share, when, in many cases, the rising earnings are little more than the fiction of new accounting practices. To this party, the public brings its greed, and Wall Street, ever willing, brings the promise of a big payoff. As in 1929, a collapsing market will expose every flaw in the free-market system; every deceit, crime, and bit of corruption will be exposed to the light of day.
This leads us to an even greater source of risk for the world: the global derivatives business. A derivative is a contract which derives its value from some underlying instrument. The underlying instrument might be a stock, bond, commodity, or currency. As an example, suppose an American beverage maker estimates it will sell $3 billion* of drinks in Japan over the next year. At today's dollar/yen exchange rate, it would make a profit. However, the beverage maker is concerned that over the next year the dollar might increase, on average, 20 per cent versus the yen. This would result in a loss to the company, as a cheaper yen would translate back home into fewer dollars. Since it does not want to lose its profit, it would approach a large bank and tell them that it has $3 billion in dollar/yen risk it wants to transfer to someone else. The bank agrees to accept the other side of this trade. Since the bank does not want a large loss, it, in turn, will seek to lay off its risk exposure onto a third party. For instance, a large Japanese automaker might want to offset its risk of selling cars in the US in dollars. In an opposite belief, the automaker is concerned that the yen may appreciate an average of 20 per cent against the dollar over the next year, thus wiping out its profits on its $3 billion in sales. The bank, then, apparently has the perfect situation. By entering into an equal but opposite trade with the Japanese automaker, the bank has transferred its risk to the Japanese company. In effect, the bank has bought and sold the same thing simultaneously, and earned two commissions in the process.
To complete the example and to show why there is so much risk, let us further assume that the beverage maker was right and the dollar's increase versus the yen did average 20 per cent over the next year. The bank would then owe the beverage maker $600 million. In return, the Japanese car company would owe the bank the same amount. Therefore, theoretically, the bank has a risk-free trade. But is it really risk-free?
The problem with the derivatives business is essentially twofold. First, the notational value of the derivatives in effect at this time is estimated to be $90 trillion. The sheer size alone is almost a certain guarantor of future problems. This dwarfs the value of all the world's stock markets combined. Second, does anyone really believe that the banks and brokers have found enough participants with acceptable risk profiles to take offsetting positions for $90 trillion when the value of the entire US stock market is only $10 trillion? Some companies have AAA credit, but many more are going to be found in the lower spectrum of credit quality, such as the likes of the Long Term Capital hedge fund which collapsed on excessive borrowing and single-handedly almost brought down the world's financial system. To make matters worse, many banks and brokers now have their own trading departments, and no longer are seeking to offset their exposure on each transaction, choosing instead to speculate on the future direction of the underlying instruments (such as the value of the dollar versus the yen) with, it might be added, what is really depositors' money.
What happens in the event of a global stock-market crash when the credit worthiness of many individuals, corporations, and governments will be called into question? Such a crash would bring wild fluctuations in the value of the stocks, bonds, commodities, and currencies which underlie every derivative transaction. How much is at risk? $30 trillion? $60 trillion? Losses totaling 5 or 10 per cent of these amounts would be enough to wipe out the capital position of every bank, broker, and financial institution on earth.
With the sophistication of computers and modern telecommunications, we have placed ourselves in a much greater risk position than in 1929. It is not a question of whether or not the system will fail, but when. The Law of Cause and Effect ever holds sway. Ultimately, the world's central bankers will not have the ability to prop up the world's collapsing financial structure.
The last deflation ended with the advent of World War II as the Allied forces increased economic production to fight the Axis powers. It may well take a similar coming together of the world's peoples to end the next deflation. Let each of us in the West hope that, if it takes a war, it will be the coming war to end for ever the suffering of the world's poor and neglected, their hunger and hopelessness, and our shame.
*The billions referred to in this article are US billions = 1,000 million
From the May 1999 issue of Share International.